FIXED INCOME I: CFA LEVEL I Fixed Income I Problem Solving Session Harvard Extension School MGMT...

L I Fixed Income I

Problem Solving Session

Harvard Extension SchoolMGMT E-2900bCFA Exam Level I

March 23, 2010

Rich GibbleLecturer

Tray SpilkerTeaching Assistant

Fixed Income I Problem Solving Session

Fixed Income

Topic Area Weights for the CFA ExamTopic Area Level I

Ethical and Professional Standards (total) 15 Quantitative Methods 12 Economics 10 Financial Reporting and Analysis 20 Corporate Finance 8 Investment Tools (total) 50 Equity Investments 10 Fixed Income 12 Derivatives 5 Alternative Investments 3 Asset Classes (total) 30 Portfolio Management and Wealth Planning (total) 5

Total 100

Features of Debt SecuritiesOverview of Bond Sectors & Instruments

Repayment & Prepayment Provisions

Fixed Income I Problem Solving Session

Study Session 15Readings 60 & 62

Fixed Income - Basic Concepts

1. A bond’s indenture:

A. outlines interest and principle components B. is the same as a debentureC. contains its covenants

1. A bond’s indenture:

A. outlines interest and principle components B. is the same as a debentureC. contains its covenants

Bond Indenture

A bond indenture specifies all rights and obligations of the issuer and bondholder.

Contains: negative covenants or restrictions on the

borrower/issuer affirmative covenants, or obligations of the borrower.

2. A five-year bond, after paying no interest for the first two years, pays $103.76 and $25 semiannually for the remaining three years until maturity. At maturity it pays $1,000. Which of the following bonds types is the closest to the bond described?

A. Accrual bondB. Deferred-coupon bondC. Step-up note

2. A five-year bond, after paying no interest for the first two years, pays $103.76 and $25 semiannually for the remaining three years until maturity. At maturity it pays $1,000. Which of the following bonds types is the closest to the bond described?

A. Accrual bondB. Deferred-coupon bondC. Step-up note

Coupon Rate Structures Accrual Bonds: pay no periodic coupon before maturity,

but are sold at par and pay-out par plus accrued at maturity.

Deferred Coupon Bonds: Initial coupon payments are deferred for some period; the accrued coupons are paid at the end of the period, before resuming normal couponing until maturity.

Step-Up Notes: have coupon rates that increase over time at a specified rate.

3. From the perspective of the bond issuer, which of the following pairs of options would add value to a straight bond?

A. Prepayment option, put optionB. Call option, accelerated sinking fund provisionC. Conversion option, put option

3. From the perspective of the bond issuer, which of the following pairs of options would add value to a straight bond?

A. Prepayment option, put optionB. Call option, accelerated sinking fund provisionC. Conversion option, put option

Provisions for Bond Retirements

Call options, sinking fund provisions, caps on floaters, and prepayment options favor the issuer.

Put options, conversion options, and floors on floaters favor the bondholder.

4. A bond with a $2,500 par value and a coupon rate of 7% makes semiannual payments. What is the dollar amount of each semiannual coupon payment?

A. $87.50B. $70.00C. $175.00

4. A bond with a $2,500 par value and a coupon rate of 7% makes semiannual payments. What is the dollar amount of each semiannual coupon payment?

A. $87.50B. $70.00C. $175.00

$2,500 (0.07/2) = $87.50

5. A $1,000 five-year semiannual 5% coupon bond issued when the market requires a yield of 6% will sell at (a) _______ for a total price of _______?

A. Par, $1,000B. Premium, $1,043.76C. Discount, $957.35

SS 15: Fixed Income - Basic Concepts

5. A $1,000 five-year semiannual 5% coupon bond issued when the market requires a yield of 6% will sell at (a) _______ for a total price of _______?

A. Par, $1,000B. Premium, $1,043.76C. Discount, $957.35

N=10, I/Y=3%, PMT=$25, FV=$1,000 compute PV = $957.35

Since the bond sells for less than face value, it sells at a discount

6. A $5 million floating-rate semiannual note is issued with a reference and spread of 6-month LIBOR + 250bps. The rate was most recently reset on January 1 when LIBOR was 6% and the risk free rate was 1.5%. How much will the next semiannual coupon payment be?

A. $112,500B. $425,000C. $212,500

6. A $5 million floating-rate semiannual note is issued with a reference and spread of 6-month LIBOR + 250bps. The rate was most recently reset on January 1 when LIBOR was 6% and the risk free rate was 1.5%. How much will the next semiannual coupon payment be?

A. $112,500B. $425,000C. $212,500

$5 mln [(0.06 + 0.025)/2] = $212,500

7. Which statement regarding caps and floors on floating rate bonds is least accurate?

A. Caps are a disadvantage to the bondholder, while floors are a disadvantage to the issuer

B. Floors are a disadvantage to the bondholder, while caps are a disadvantage to the issuer

C. Caps are an advantage to issuers, while floors are an advantage to bondholders

7. Which statement regarding caps and floors on floating rate bonds is least accurate?

A. Caps are a disadvantage to the bondholder, while floors are a disadvantage to the issuer

B. Floors are a disadvantage to the bondholder, while caps are a disadvantage to the issuer

C. Caps combined with floors are called collars

Caps & Floors on Floating-Rate Bonds

Caps: if rates move above the cap rate, the issuer only pays the cap rate advantage issuer

Floors: if rates move below the floor rate, the issuer still pays the floor rate advantage bondholder

8. A 5% semiannual, $1,000 face value bond is quoted at a 2.7% discount to par. The quote is made mid-way between coupon payment dates. What is the bond’s clean price, dirty price and accrued interest?

A. $960.50, $973.00, $12.50B. $973.00, $985.50, $12.50 C. $950.00, $1,000.00, $50.00

8. A 5% semiannual, $1,000 face value bond is quoted at a 2.7% discount to par. The quote is made mid-way between coupon payment dates. What is the bond’s clean price, dirty price and accrued interest?

A. $960.50, $973.00, $12.50B. $973.00, $985.50, $12.50 C. $950.00, $1,000.00, $50.00

Bond Quotes and Accrued Interest

Full Price = Clean Price + Accrued Interest

• Full (Dirty) Price = quoted or selling price = $1,000(1 – 0.027) x = $973

• Accrued Interest = $1,000(0.05/4) = $12.50• Clean Price = Full Price – Accrued Interest

= $973 – $12.50 = $960.50

Questions 9 – 12:

Consider a 15-year, $10 million par value, 7.5% coupon bond issued on Jan 1, 2010. The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity. There is a sinking fund provision requiring redemptions of $666,667 of the principal per year at par. Current market rates for comparable bonds are 7%.

Questions 9 – 12:9. Based on the above, investors can conclude:

A. they will pay a premium for the call optionB. the bonds were issued at a premiumC. the bonds do not have call protection

9. Based on the above, investors can conclude:

A. they will pay a premium for the call optionB. the bonds were issued at a premiumC. the bonds do not have call protection

9. Based on the above, investors can conclude:

A. they will pay a premium for the call option Benefit of call option accrues to the issuer

B. the bonds were issued at a premium Indeterminable: call option calls for a discount while

coupon variance calls for a premium

C. the bonds do not have call protection The call calendar begins from the date of issuance;

The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity.

Questions 9 – 12 (cont.):10.Based on the above, which of the following

statements is least accurate regarding the sinking fund provision?

A. The bonds have an accelerated sinking fund provision.B. An investor would not benefit if their bonds were

redeemed under the provision.C. The issuer would benefit if they delivered cash against

the provision.

10. Based on the above, which of the following statements is least accurate regarding the sinking fund provision?

A. The bonds have an accelerated sinking fund provision.

B. An investor would not benefit if their bonds were redeemed under the provision.

C. The issuer would benefit if they delivered cash against the provision.

10. Explained• There was no provision for an accelerated

sinking fund.• Bond will be trading at a premium because

coupon rate > current market rate. Thus, a call at par would not benefit the investor.

• The issuer would likely deliver cash to the trustee (at par) rather than buying bonds at a premium in the open market to satisfy the call.

Questions 9 – 12 (cont.):11. Based on the above, if the bonds were

called on July 1, 2015, an investor who purchased the entire issuance would receive?

A. $10,300,000B. $10,500,000C. $10,000,000

11.Based on the above, if the bonds were called on July 1, 2016, an investor who purchased the entire issuance would receive?

A. $10,300,000B. $10,500,000C. $10,000,000

“The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity.” Call between 1/1/10 – 12/31/15 = 105 x $10mln = $10.5mln Call between 1/1/16 – Maturity = 103 x $10mln = $10.3mln

Questions 9 – 12 (cont.):12. Based on the above, if the bonds were not

callable and had no sinking fund provision, they would have been issued at a ______ for $_______?

A. Discount, $9,554,269B. Premium, $10,455,395C. Premium, $10,459,801

12. Based on the above, if the bonds were not callable and had no sinking fund provision, they would have been issued at a ______ for $_______?

A. Discount, $9,554,269B. Premium, $10,455,395C. Premium, $10,459,801

12. Explained

N = 30, I/Y = 0.07/2 = 3.5%, PMT = 0.075/2 x $10mln = $375,000, FV = $10mln Compute PV = $10,459,801

Unless specified otherwise, bonds are assumed to be semiannual pay

13. An investor buying bonds on margin:

A. will pay higher funding costs than they would if using a repurchase agreement (repo)

B. pays interest on a loan collateralized by the bonds

C. loans the bonds to an institution “overnight”

13. An investor buying bonds on margin:

A. will pay higher funding costs than they would if using a repurchase agreement (repo)

B. pays interest on a loan collateralized by the bonds

C. loans the bonds to an institution “overnight”

13. Explained Margin loans require the payment of interest to

the lender and are typically at higher rates than a repurchase agreement.

A Repurchase agreement allows an institution to sell a security with a commitment to buy it back at a later date. Typically lower implied interest due to the fact that the “lender” holds the collateral during the term.

14. Which of the following is most likely a provision for the early retirement of debt?

A. A put optionB. A conversion optionC. A prepayment option

14. Which of the following is most likely a provision for the early retirement of debt?

A. A put optionB. A conversion optionC. A prepayment option

A prepayment option allows the borrower/issuer the right to prepay the loan balance prior to maturity

15. A mortgage is most likely:

A. an amortizing loanB. characterized by unstable cash flowsC. a bullet maturity loan

15. A mortgage is most likely:

A. an amortizing loanB. characterized by unstable cash flowsC. a bullet maturity loan Amortizing securities make periodic principle and interest

over the life of the bond, whereas a bullet maturity bond pays periodic interest over the life of the bond and a large principle payment at maturity.

Mortgages often have prepayment options, thus make cash flows unpredictable due to the possibility of prepayment.

16. A treasury quoted at 95:15 with par value of $100,000 has a dollar equivalent quote of:

A. $95,468.75B. $100,000.00C. $95,150.00

16. A treasury quoted at 95:15 with par value of $100,000 has a dollar equivalent quote of:

A. $95,468.75B. $100,000.00C. $95,150.00

95(15/32)% x $100,000 = 0.9546875 x $100,000 = $95, 468.75

17. A $1,000 par value TIPS bond carries a 3% semiannual coupon. If the annual inflation rate is 5%, what is the principal value of the bond and coupon payment after six months.

A. $1,030, $15.45B. $1,025, $15.38C. $1,050, $15.75

17. A $1,000 par value TIPS bond carries a 3% semiannual coupon. If the annual inflation rate is 5%, what is the principal value of the bond and coupon payment after six months.

A. $1,030, $15.45B. $1,025, $15.38C. $1,050, $15.75 Adjusted principle = $1,000(1+0.05/2) = $1,025 Coupon = new principle x coupon rate = $1,025(0.03/2)

= $15.375 ≈ $15.38

18. Ceteris paribus, put the following three equal par value bonds in order from highest to lowest value: (1) a Treasury note (T-note) principal strip that has six months remaining until maturity, (2) a Treasury bond (T-bond) coupon strip with six months remaining until maturity, and (3) a newly issued six-month Treasury bill (T-bill):

A. 1 < 2 < 3B. 3 < 2 < 1C. 1 = 2 = 3

18. Ceteris paribus, put the following three equal par value bonds in order from highest to lowest value: (1) a Treasury note (T-note) principal strip that has six months remaining until maturity, (2) a Treasury bond (T-bond) coupon strip with six months remaining until maturity, and (3) a newly issued six-month Treasury bill (T-bill):

A. 1 < 2 < 3B. 3 < 2 < 1C. 1 = 2 = 3

18. Explained: Assume 5% yield.

$975.61 = $975.61 = $975.61

N=1; I/Y=5/2=2.5; PMT=0; FV=1,000CPT PV = $975.61

$1,000 T-Note POw/ 6-mo to

maturity

$1,000 T-Bond CIw/ 6-mo to

maturity

$1,000 6-mo T-Bill

18. Explained: “The reason why a distinction is made

between coupon strips and the principal strips has to do with the tax treatment by non-U.S. entities…”

19. Which of the following muni-bonds generally has the lowest risk with subsequently lower yields?

A. Revenue bondsB. Unlimited tax general obligation bondsC. Limited tax general obligation bonds

19. Which of the following muni-bonds generally has the lowest risk with subsequently lower yields?

A. Revenue bondsB. Unlimited tax general obligation bondsC. Limited tax general obligation bonds

20. A bond that is back-stopped by a 3rd party is referred to as a:

A. Prerefunded bondB. Double barreled bondC. Insured bond

20. A bond that is back-stopped by a 3rd party is referred to as a:

A. Prerefunded bondB. Double barreled bondC. Insured bond

20. Explained: Prerefunded bond: serviced by cash flows

generated from a pool of Treasury securities Double barreled: a special class of G.O. bond

issued with the full taxing authority of the issuer along with other resources: i.e., fees, grants, and special charges.

Insured bond: bond carrying a 3rd party guarantee

21. Which of the following bond types most closely matches a bond issuance where all bonds are sold at one time, with the same coupon rate and maturity?

A. Medium-term notesB. Corporate debenturesC. Shelf registered, SEC 415 bond

21. Which of the following bond types most closely matches a bond issuance where all bonds are sold at one time, with the same coupon rate and maturity?

A. Medium-term notesB. Corporate debenturesC. Shelf registered, SEC 415 bond

21. Explained

Medium-term notes: registered under SEC Rule 415 (shelf registration), meaning that they need not all be sold at one time, and are “shelved” at the discretion of the issuer to be sold over time.

Corporate debentures: an unsecured corporate bond, typically issued all at once, sold on a firm commitment (guaranteed) by the underwriting syndicate, and comprised of bonds with a single coupon rate and maturity.

Shelf registered, SEC 415 bond: a medium-term note.

22. Compared to bankers acceptances, negotiable CDs:

A. are less likely to defaultB. are more liquidC. have shorter maturities on average

22. Compared to bankers acceptances, negotiable CDs:

A. are less likely to defaultB. are more liquidC. have shorter maturities on averageNegotiable CDs are typically longer term and pay periodic interest versus shorter term bankers acceptances that pay no periodic interest. Both securities are as good as the credit rating of the issuing bank. CDs can be sold in the secondary market and have more liquidity than BAs.

23. Primary market activities for debt securities would most likely include:

A. a best-efforts offeringB. market makingC. over-the-counter transactions

23. Primary market activities for debt securities would most likely include:

A. a best-efforts offeringB. market makingC. over-the-counter transactions

Best-efforts offering, firm commitment, auction process are all primary market activities. Market making and OTC transactions are secondary activities.

24. A CDO will least likely be backed by which of the following security types:

A. preferred equitiesB. student loan receivablesC. CDOs

24. A CDO will least likely be backed by which of the following security types:

A. preferred equitiesB. student loan receivablesC. CDOs

By definition, a CDO is backed by a pool of debt instruments, which may include loans, mortgages, emerging market debt, corporate bonds, and ABS.

Ethics & Professional Standards

Fixed Income

Topic Area Weights for the CFA ExamTopic Area Level I

Ethical and Professional Standards (total) 15 Quantitative Methods 12 Economics 10 Financial Reporting and Analysis 20 Corporate Finance 8 Investment Tools (total) 50 Equity Investments 10 Fixed Income 12 Derivatives 5 Alternative Investments 3 Asset Classes (total) 30 Portfolio Management and Wealth Planning (total) 5

Total 100

L I Ethics Item Set

CFA Sample QuestionsAnthony Buchard, CFA, disclosed a complaint by a former client on his annual professional conduct statement. The CFA Institute Professional Conduct Program sent Buchard a Notice of Inquiry and requested a copy of the client complaint. Buchard provided a copy of the complaint; however, several parts of the complaint were blackened out. Buchard refused to provide a complete copy of the complaint because it contained confidential client information. According to the Standards of Practice Handbook, Buchard should:A. provide a complete copy of the complaint to the Professional

Conduct Program.B. maintain all client information as confidential, including the

information contained in the client complaint.C. sign a confidentiality agreement with the client that requires

Buchard to keep the client complaint confidential.

L I Ethics Item Set

CFA Sample QuestionsAnthony Buchard, CFA, disclosed a complaint by a former client on his annual professional conduct statement. The CFA Institute Professional Conduct Program sent Buchard a Notice of Inquiry and requested a copy of the client complaint. Buchard provided a copy of the complaint; however, several parts of the complaint were blackened out. Buchard refused to provide a complete copy of the complaint because it contained confidential client information. According to the Standards of Practice Handbook, Buchard should:A. provide a complete copy of the complaint to the Professional

Conduct Program.B. maintain all client information as confidential, including the

information contained in the client complaint.C. sign a confidentiality agreement with the client that requires

Buchard to keep the client complaint confidential.

L I Ethics Item Set

CFA Sample QuestionsProfessional Conduct Investigations by CFA Institute: “The requirements of Standard III(E) [Preservation of Confidentiality] are not intended to prevent members and candidates from cooperating with an investigation by CFA Institute’s Professional Conduct Program (PCP). When permissible under applicable law, members and candidates shall consider the PCP an extension of themselves when requested to provide information about a client in support of a PCP investigation into their own conduct.”

- Standards of Practice Handbook, 9th Ed., Pg. 79

L I Ethics Item Set

CFA Sample QuestionsBeth Patrick, a fixed income analyst at a brokerage company, assists her company’s traders by developing in-house bond ratings to supplement those of the major bond rating services. The traders use disparities in the ratings to construct profitable investment strategies. Patrick makes inferences from nonmaterial private information and news events, which she reflects in her bond ratings. Patrick’s approach: A. reflects the mosaic theory. B. violates confidentiality rules. C. violates insider trading rules.

L I Ethics Item Set

CFA Sample QuestionsBeth Patrick, a fixed income analyst at a brokerage company, assists her company’s traders by developing in-house bond ratings to supplement those of the major bond rating services. The traders use disparities in the ratings to construct profitable investment strategies. Patrick makes inferences from nonmaterial private information and news events, which she reflects in her bond ratings. Patrick’s approach: A. reflects the mosaic theory. B. violates confidentiality rules. C. violates insider trading rules.

L I Ethics Item Set

CFA Sample QuestionsMosaic Theory: “…The analyst may use significant conclusions derived from the analysis of public and nonmaterial nonpublic information as the basis for investment recommendations and decisions even if those conclusions would have been material inside information had they been communicated directly to the analyst by a company. Under ‘mosaic theory,’ financial analysts are free to act on this collection, or mosaic, of information without risking violation.”

- Standards of Practice Handbook, 9th Ed., Pg. 39

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