Kylie Autumn, CFA, is a consultant with Tri-Vision Group. Robert Lullum, Senior Vice President at Langsford Investments, has asked for assistance with the evaluation of mortgage-backed and collateralized mortgage obligation (CMO) derivative securities for potential inclusion in several client portfolios. Langsford Investments mainly deals with equity investments and REITs, but the company recently purchased a small firm that invests mainly in fixed-income securities.Lullum has done some research on the appropriate spread measures and option valuation models for fixed-income securities and wants to clarify some points. He wants to know if the following statements are correct:Statement 1: The proper spread measure for option-free corporate bonds is the nominal spread.Statement 2: Callable corporate bonds and mortgage-backed securities should be measured using the option-added spread.Statement 3: The Z-spread is appropriate for credit card ABS and auto loan ABS.While Lullum meets with Autumn, Janet Van Ark, CFA charterholder and equity-income portfolio manager for Langsford, is attempting to purchase bonds that may also provide her with equity exposure in the future. She has decided to analyze an 8% annual coupon bond with exactly 20 years to maturity. The bonds are convertible into 10 common shares for each $ 1,000 of par (face) value. The bond's market price is $920, and the common stock has a market price of $40. Van Ark estimates that the stock will increase in value to $70 within the next two years. The stock's annual dividend is $0.40 per share, and the market yield on comparable non-convertible bonds'is 9.5%.Carl Leighton, a Langsford analyst and Level 2 CFA candidate, works with mortgage-backed and other asset-based securities. He provides Lullum with a list of credit enhancements for asset-backed securities, which includes letters of credit, excess servicing spread funds, over-collateralization, and bond insurance. Lullum then asks him for a status report of the firm's exposure to paythrough securities. He also asks Leighton to calculate the single-monthly mortality rate (SMM) and estimate the prepayment for the month for a seasoned mortgage pool with a $500,000 principal balance remaining. The scheduled monthly principal payment is $ 150 and the conditional prepayment rate (CPR) is 7%.How many of the three statements on appropriate spread measures and valuation models are correct?
Answer(s): B
Statement 1 is incorrect. The Z-spread is the appropriate spread measure for option-free corporate bonds. Statement 2 is also incorrect, as it should say option-adjusted spread or "option-re moved spread." Statement 3 is correct. (Study Session 15, LOS 57. i)
Kylie Autumn, CFA, is a consultant with Tri-Vision Group. Robert Lullum, Senior Vice President at Langsford Investments, has asked for assistance with the evaluation of mortgage-backed and collateralized mortgage obligation (CMO) derivative securities for potential inclusion in several client portfolios. Langsford Investments mainly deals with equity investments and REITs, but the company recently purchased a small firm that invests mainly in fixed-income securities.Lullum has done some research on the appropriate spread measures and option valuation models for fixed-income securities and wants to clarify some points. He wants to know if the following statements are correct:Statement 1: The proper spread measure for option-free corporate bonds is the nominal spread.Statement 2: Callable corporate bonds and mortgage-backed securities should be measured using the option-added spread.Statement 3: The Z-spread is appropriate for credit card ABS and auto loan ABS.While Lullum meets with Autumn, Janet Van Ark, CFA charterholder and equity-income portfolio manager for Langsford, is attempting to purchase bonds that may also provide her with equity exposure in the future. She has decided to analyze an 8% annual coupon bond with exactly 20 years to maturity. The bonds are convertible into 10 common shares for each $ 1,000 of par (face) value. The bond's market price is $920, and the common stock has a market price of $40. Van Ark estimates that the stock will increase in value to $70 within the next two years. The stock's annual dividend is $0.40 per share, and the market yield on comparable non-convertible bonds'is 9.5%.Carl Leighton, a Langsford analyst and Level 2 CFA candidate, works with mortgage-backed and other asset-based securities. He provides Lullum with a list of credit enhancements for asset-backed securities, which includes letters of credit, excess servicing spread funds, over-collateralization, and bond insurance. Lullum then asks him for a status report of the firm's exposure to paythrough securities. He also asks Leighton to calculate the single-monthly mortality rate (SMM) and estimate the prepayment for the month for a seasoned mortgage pool with a $500,000 principal balance remaining. The scheduled monthly principal payment is $ 150 and the conditional prepayment rate (CPR) is 7%.Van Ark computes the convertible bond's market conversion premium per share (MCPPS) using only the information given, and then wants to know how a sudden increase in the stock price of $2 would impact the bond price. Which of the following choices is most correct?
The MCPPS is the difference between the conversion value and the bond's current market price, on a per share basis. per shareRegarding the stock price increase, the convertible bond is essentially a straight bond (i.e., no conversion privilege), plus a call option on the underlying common stock. In this case, the option is far out of the money. So, while the increase in the stock price will have a positive impact on the bond, the impact will be small because the delta is close to zero for options that arc far out of the money (Study Session 14, LOS 57.i)
Kylie Autumn, CFA, is a consultant with Tri-Vision Group. Robert Lullum, Senior Vice President at Langsford Investments, has asked for assistance with the evaluation of mortgage-backed and collateralized mortgage obligation (CMO) derivative securities for potential inclusion in several client portfolios. Langsford Investments mainly deals with equity investments and REITs, but the company recently purchased a small firm that invests mainly in fixed-income securities.Lullum has done some research on the appropriate spread measures and option valuation models for fixed-income securities and wants to clarify some points. He wants to know if the following statements are correct:Statement 1: The proper spread measure for option-free corporate bonds is the nominal spread.Statement 2: Callable corporate bonds and mortgage-backed securities should be measured using the option-added spread.Statement 3: The Z-spread is appropriate for credit card ABS and auto loan ABS.While Lullum meets with Autumn, Janet Van Ark, CFA charterholder and equity-income portfolio manager for Langsford, is attempting to purchase bonds that may also provide her with equity exposure in the future. She has decided to analyze an 8% annual coupon bond with exactly 20 years to maturity. The bonds are convertible into 10 common shares for each $ 1,000 of par (face) value. The bond's market price is $920, and the common stock has a market price of $40. Van Ark estimates that the stock will increase in value to $70 within the next two years. The stock's annual dividend is $0.40 per share, and the market yield on comparable non-convertible bonds'is 9.5%.Carl Leighton, a Langsford analyst and Level 2 CFA candidate, works with mortgage-backed and other asset-based securities. He provides Lullum with a list of credit enhancements for asset-backed securities, which includes letters of credit, excess servicing spread funds, over-collateralization, and bond insurance. Lullum then asks him for a status report of the firm's exposure to paythrough securities. He also asks Leighton to calculate the single-monthly mortality rate (SMM) and estimate the prepayment for the month for a seasoned mortgage pool with a $500,000 principal balance remaining. The scheduled monthly principal payment is $ 150 and the conditional prepayment rate (CPR) is 7%.Which of the following statements about interest-only (10) and principal-only (PO) strips is least accurate?
IO investors want prepayments to be slow and thus are more concerned with contraction risk.Interest-only strips: An interest-only (IO) strip receives all interest payments from the underlying mortgage pool. If market interest rates increase, prepayments will fall. This results in larger than expected principal balances and, thus, larger than expected interest payments. Hence. IO strips have higher realized returns when interest rates increase. If interest rates fall, the pool tends to prepay and interest payments fall, resulting in lower returns to the IO strip.Principal-only strips: A principal-only (PO) strip receives only the principal payments (both scheduled and prepayments) from the underlying pool of mortgages. If interest rates fall, prepayments increase. Since the PO strips arc discount securities, larger than expected prepayments result in the early return of principal and thus a higher return on the security. Increasing interest rates result in lower than expected prepayments (i.e., extension risk) and lower actual returns.Volatility: Both IOs and POs have greater price volatility than the passthrough from which they were derived. This occurs because the IO and PO returns are negatively correlated (they respond in opposite directions to changes in interest rates), but the volatility of the combined IO and PO strips equals the price volatility of the source passthrough.(Study Session 15, LOS 55-i)
Kylie Autumn, CFA, is a consultant with Tri-Vision Group. Robert Lullum, Senior Vice President at Langsford Investments, has asked for assistance with the evaluation of mortgage-backed and collateralized mortgage obligation (CMO) derivative securities for potential inclusion in several client portfolios. Langsford Investments mainly deals with equity investments and REITs, but the company recently purchased a small firm that invests mainly in fixed-income securities.Lullum has done some research on the appropriate spread measures and option valuation models for fixed-income securities and wants to clarify some points. He wants to know if the following statements are correct:Statement 1: The proper spread measure for option-free corporate bonds is the nominal spread.Statement 2: Callable corporate bonds and mortgage-backed securities should be measured using the option-added spread.Statement 3: The Z-spread is appropriate for credit card ABS and auto loan ABS.While Lullum meets with Autumn, Janet Van Ark, CFA charterholder and equity-income portfolio manager for Langsford, is attempting to purchase bonds that may also provide her with equity exposure in the future. She has decided to analyze an 8% annual coupon bond with exactly 20 years to maturity. The bonds are convertible into 10 common shares for each $ 1,000 of par (face) value. The bond's market price is $920, and the common stock has a market price of $40. Van Ark estimates that the stock will increase in value to $70 within the next two years. The stock's annual dividend is $0.40 per share, and the market yield on comparable non-convertible bonds'is 9.5%.Carl Leighton, a Langsford analyst and Level 2 CFA candidate, works with mortgage-backed and other asset-based securities. He provides Lullum with a list of credit enhancements for asset-backed securities, which includes letters of credit, excess servicing spread funds, over-collateralization, and bond insurance. Lullum then asks him for a status report of the firm's exposure to paythrough securities. He also asks Leighton to calculate the single-monthly mortality rate (SMM) and estimate the prepayment for the month for a seasoned mortgage pool with a $500,000 principal balance remaining. The scheduled monthly principal payment is $ 150 and the conditional prepayment rate (CPR) is 7%.Which of the following pairs correctly identifies the two external credit enhancements in Leighton's list?
Answer(s): C
Excess servicing spread funds (a type of reserve fund) and overcoI lateralization are internal credit enhancements. Letters of credit and bond insurance are external enhancements. (Study Session 15, LOS 56.d)
Mike Diffle has been asked to evaluate the bonds of Hardin, Inc. The specific issue Diffle is considering has an 8% annual coupon and matures in two years. The bonds are currently callable at 101, and beginning in six months, they are callable at par. Bratton Corp, a competitor of Hardin's, also has bonds outstanding which are identical to Hardin's except that they are not callable. Diffle believes that the AA rating of both bonds is an accurate reflection of their credit risk. Diffle is wondering if the Bratton bonds might be a better investment than the Hardin bonds. Assume that the following 1-year interest rate tree is used to value bonds with a maturity of up to three years (this tree assumes interest rate volatility of 10%).Also, assume that the appropriate spot rates for securities maturing in one, two, and three years are 7.25%, 7.5%, and 7.80%, respectively.Diffle believes he should begin his analysis with the option-free Bratton bonds. He decides to consider two different approaches to valuing the Bratton Bonds—one that uses the current spot rate curve and another that uses the interest rate tree given above.For the next step in his analysis, Diffle has decided to calculate the value of the Hardin bonds using the interest rate tree. His assumption is that the bond will be called at any node of the tree where the calculated value exceeds the call price. Diffle summarizes the results of his bond valuation analysis in a memo to his supervisor, Luke Puldo. In this memo, Diffle makes the following statements:Statement 1: The value of the option embedded in the Hardin bonds can be derived by simply subtracting the interest rate tree value of the Hardin bonds from the interest rate tree value of the Bratton bonds.Statement 2: I am concerned that the 10% volatility assumption used to develop the interest rate tree might be too low. A higher volatility assumption would result in a lower value for the Hardin bonds.After reviewing Diffle's analysis, Puldo notes that Diffle has not included any information on the option adjusted spread (OAS) for the Hardin bonds. Puldo suggests that Diffle should evaluate the OAS in order to get an idea of the liquidity risk of the Hardin bonds. Diffle counters that the OAS may not be very informative in this case, since he is uncertain as to the reliability of the interest rate volatility assumption.To finish his analysis, Diffle would like to use his binomial model to evaluate the interest rate risk of both the Hardin bonds and the Bratton bonds. Diffle has shocked interest rates by 25 basis points throughout the interest rate tree he has been using to value the two bond issues. Using the new rates, Diffle has calculated values for the bonds assuming a 25-basis-point increase or decrease in rates. He plans to use these values as inputs into the following formulas for duration and convexity:duration = convexity = Calculate the value of the Bratton bonds using the interest rate tree.
Interest rate tree: Discount maturity value back one year at different 1-year forward rates, then take the equally weighted average of those values discounted back to today at today's 1- year rate:V = 0.5 x [(108 / 1.08530) + 8] / 1.0725 + 0.5 x [(108 /1.06983) + 8] / 1.0725V = 0.5 x (99.512 + 8) /1.0725 + 0.5 x (100.951 + 8) / 1.0725V = 50.122+ 50.793 = 100.915Today Year 1 Year 2 108 107.512 100.915 108 108.951 108(Study Session 14.LOS 54.c,d)
Post your Comments and Discuss CFA CFA-Level-II exam prep with other Community members:
Our website is free, but we have to fight against AI bots and content theft. We're sorry for the inconvenience caused by these security measures. You can access the rest of the CFA-Level-II content, but please register or login to continue.