Talha Farooqi - Assignment 01 - Overview of Bond Sectors and Instruments - Fixed Income Analysis PDF

KARACHI UNIVERSITY BUSINESS SCHOOL
SUBJECT: FIXED INCOME ANALYSIS

ASSIGNMENT # 01
TOPIC:
OVERVIEW OF BOND SECTORS AND INSTRUMENT
COURSE INSTRUCTOR:
SIR SHOAIB HASHMI
SUBMITTED BY:
TALHA FAROOQI
PROBLEM No. 04
Suppose a portfolio manager purchases $1 million of par value of a Treasury inflation
protection security. The real rate (determined at the auction) is 3.2%.
a. Assume that at the end of the first six months the CPI-U is 3.6% (annual rate).
(i) Inflation adjustment to principal at the end of the first six months,
(ii) The inflation-adjusted principal at the end of the first six months, and
(iii) The coupon payment made to the investor at the end of the first six months.
b. Assume that at the end of the second six months the CPI-U is 4.0% (annual rate).
(i) Inflation adjustment to principal at the end of the second six months
(ii) The inflation-adjusted principal at the end of the second six months, and
(iii) The coupon payment made to the investor at the end of the second six months.
SOLUTION OF 4 (a)
Since the inflation rate (as measured by the CPI-U) is 3.6%, the semiannual inflation
rate for adjusting the principal is 1.8%.
(i) The inflation adjustment to the principal is $1,000,000 × 0.018% = $18,000
(ii) The inflation-adjusted principal is $1,000,000 + the inflation adjustment to the principal
= $1,000,000 + $18,000 = $1,018,000
(iii)The coupon payment is equal to inflation-adjusted principal × (real rate/2) = $1,018,000
× (0.032/2) = $16,288.00
SOLUTION OF 4 (b)
Since the inflation rate is 4.0%, the semiannual inflation rate for adjusting the principal
is 2.0%.
(i) The inflation adjustment to the principal is $1,018,000 × 0.02% = $20,360

(ii) The inflation-adjusted principal is $1,018,000 + the inflation adjustment to the principal
= $1,018,000 + $20,360 = $1,038,360
(iii)The coupon payment is equal to inflation-adjusted principal × (real rate/2) = $1,038,360
× (0.032/2) = $16,613.76
PROBLEM NO. 05
Suppose that a 15-year mortgage loan for $200,000 is obtained. The mortgage is a level-
payment, fixed-rate, fully amortized mortgage. The mortgage rate is 7.0% and the
monthly mortgage payment is $1,797.66.
a. Compute an amortization schedule for the first six months.

b. What will the mortgage balance be at the end of the 15th year?
c. If an investor purchased this mortgage, what will the timing of the cash flow be
assuming that the borrower does not default?
SOLUTION OF 5 (a):
Monthly mortgage payment = $1,797.66
Monthly mortgage rate = 0.00583333 (0.07/12)
Month Opening Loan Loan Interest Schedule Principal Closing Loan

Balance Payment Payment Balance
1 200,000.00 1,797.66 1,166.67 630.99 199,369.01
2 199,369.01 1,797.66 1,162.99 634.67 198,734.34
3 198,734.34 1,797.66 1,159.28 638.37 198,095.97
4 198,095.97 1,797.66 1,155.56 642.10 197,453.87
5 197,453.87 1,797.66 1,151.81 645.84 196,808.03
6 196,808.03 1,797.66 1,148.05 649.61 196,158.42
SOLUTION OF 5 (b):
In the last month (month 180), after the final monthly mortgage payment is made, the
ending mortgage balance will be zero. That is, the mortgage will be fully paid.
SOLUTION OF 5 (c):
The cash flow is unknown even if the borrower does not default. This is because the
borrower has the right to prepay in whole or in part the mortgage balance at any time.
PROBLEM NO. 13
a. What is a collateralized debt obligation?

b. What distinguishes an arbitrage transaction from a balance sheet transaction?
(a) COLLATERALIZED DEBT OBLIGATION
A collateralized debt obligation is a structure backed by a portfolio of one or more

fixed income products—corporate bonds, asset-backed securities, mortgage backed
securities, bank loans, and other CDOs. Funds are raised to purchase the assets by
the sale of the CDO. An asset manager manages the assets.
(b) DISTINCTION BETWEEN AN ARBITRAGE TRANSACTION FROM A

BALANCE SHEET TRANSACTION
The distinction between an arbitrage transaction from a balance sheet transaction is

based on the motivation of the sponsor of the CDO. Arbitrage transactions are
motivated by the objective to capture the spread between the yield offered on the
pool of assets underlying the CDO and the cost of borrowing which is the yield
offered to sell the CDO. In balance sheet transactions, typically undertaken by
financial institutions such as banks and insurance companies, the motivation is to
remove assets from the balance sheet thereby obtaining capital relief in the form of
lower risk-based capital requirements.

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KARACHI UNIVERSITY BUSINESS SCHOOL

SUBJECT: FIXED INCOME ANALYSIS

(i) The inflation adjustment to the principal is $1,018,000 × 0.02% = $20,360

a. Compute an amortization schedule for the first six months.

Month Opening Loan Loan Interest Schedule Principal Closing Loan

a. What is a collateralized debt obligation?

(a) COLLATERALIZED DEBT OBLIGATION

A collateralized debt obligation is a structure backed by a portfolio of one or more

(b) DISTINCTION BETWEEN AN ARBITRAGE TRANSACTION FROM A

The distinction between an arbitrage transaction from a balance sheet transaction is

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