Questions and answer

What risks does an investor who purchases a French corporation bond whose cash flows are
denominated in euros face?

A non-dollar-denominated bond has unknown U.S. dollar cash flows. The dollar cash flows are
dependent on the exchange rate at the time the payments are received. For example, suppose that an
investor purchases a bond whose payments are in euros.

What can you say about the relative price volatility of a bond in a high-interest-rate environment
compared to a low-interest-rate environment?

We can say that there is more volatility in a low-interest-rate environment because there was a greater
fall (−7.23% versus −5.94%).

“The price of a floater will always trade at its par value.”

One would disagree with the statement: “The price of a floater will always trade at its par value.”

First, the coupon rate of a floating-rate security (or floater) is equal to a reference rate plus some spread
or margin. Next, the price of a floater depends on two factors: (1) the spread over the reference rate
and (2) any restrictions that may be imposed on the resetting of the coupon rate.

The price of a floater will trade close to its par value as long as (1) the spread above the reference rate
that the market requires is unchanged and (2) neither the cap nor the floor is reached.

What is the total return for a 20-year zero-coupon bond that is offering a yield to maturity of 8% if the
bond is held to maturity?

For zero-coupon bonds, none of the bond’s total dollar return is dependent on the interest-on-interest
component, so a zero-coupon bond has zero reinvestment risk if held to maturity. The yield earned on a
zero-coupon bond held to maturity is equal to the promised yield to maturity.

The price value of a basis point will be the same regardless if the yield is increased or decreased by 1
basis point. However, the price value of 100 basis points (i.e., the change in price for a 100-basis-point
change in interest rates) will not be the same if the yield is increased or decreased by 100 basis points.
Why?

The convex relationship explains why. When the price-yield relationship for any option-free bond is
graphed, it displays a convex shape. When the price of the option-free bond declines, we can observe
that the required yield rises. However, this relationship is not linear. The convex shape of the price-yield
relationship generates four properties concerning the price volatility of an option-free bond.

First, although the prices of all option-free bonds move in the opposite direction from the change in
yield required, the percentage price change is not the same for all bonds. Second, for very small changes
in the yield required (like 1 basis point), the percentage price change for a given bond is roughly the
same, whether the yield required increases or decreases. Third, for large changes in the required yield
(like 100 basis points), the percentage price change is not the same for an increase in the required yield
as it is for a decrease in the required yield. Fourth, for a given large change in basis points, the
percentage price increase is greater than the percentage price decrease.
When discussing the volatility of a bond (changes in its price), there are some key factors to
consider: the time to maturity, the coupon rate, and the yield to maturity (the expected rate of
return).
- Coupon Rate and Time to Maturity: A bond with a lower coupon rate tends to be more
volatile in price. As the time to maturity of the bond increases, the volatility in its price
also tends to increase.
However, if you compare two bonds with similar coupon rates and close maturity periods,
differences in volatility may not be very evident.
- Coupon Rate and Yield to Maturity: A lower coupon rate is also associated with higher
volatility in the bond's price. Keeping the coupon rate and time to maturity constant, a
higher yield to maturity tends to reduce price volatility.

Important Properties:
How the required yield changes affects the volatility of the bond price. The convexity
(curvature) of the relationship between price and yield plays a crucial role.
For small changes in the required yield, all bonds may show similar percentage changes in price,
but for large changes, the direction of the change matters.
When there are significant changes, a percentage increase in price is greater than a percentage
decrease, affecting volatility.

If interest rates are expected to fall, investors may prefer bonds with longer maturities to
increase price volatility.
If an increase in interest rates is anticipated, bonds with shorter maturities might be preferable
to reduce price volatility.

You are a portfolio manager who has presented a report to a client. The report indicates the duration
of each security in the portfolio. One of the securities has a maturity of 15 years but a duration of 25.
The client believes that there is an error in the report because he believes that the duration cannot be
greater than the security’s maturity. What would be your response to this client?

Unfortunately, market participants often confuse the main purpose of duration by constantly referring
to it as some measure of the weighted average life of a bond. This is because of the original use of
duration by Macaulay where the cash flow for each period divided by the market value formed a weight
with the weights adding up to one. If you rely on this interpretation of duration, it will be difficult for you
to understand why a security with a maturity of 15 years can have a duration greater than 15 years.

Duration is the approximate percentage change in price for a small change in interest rates. Thus, a CMO
bond class with a duration of 25 means that for a 100-basis-point change in yield, that bond’s price will
change by roughly 25%. Similarly, we interpret the duration of an option in the same way.

“If two portfolios have the same duration, the change in their value when interest rates change will be
the same.” Explain why you agree or disagree with this statement.
While duration is a valuable metric for estimating an asset's sensitivity to small changes in yield and
provides a good approximation of the percentage price change, it has limitations, especially for large
changes in yield. Convexity helps supplement the approximate price change provided by duration.

In a portfolio context, the duration is the weighted average of each asset's duration. However, portfolios
with the same duration may not have the same assets, proportions of assets, or maturities. Changes in
interest rates can impact the duration of each portfolio's assets differently, especially if the changes are
different for various maturities. Even if two portfolios have the same duration, their value changes may
not necessarily be the same when interest rates change.

Why is an option-adjusted spread more suitable for a bond with an embedded option than a yield
spread?

A bond with an option can be broken down into both a bond and an option. Thus, it stands to reason
that a spread for this type of bond should take into consideration the aspects of an option that can
impact the spread. The option-adjusted spread is the measure that is used to adjust for any options
embedded in a bond issue.

For a bond with embedded options, its option-adjusted spread is the spread at which it presumably
would be trading over a benchmark if it had no embedded optionality.

What is an embedded option in a bond?

An embedded option is an option found in a bond that includes a provision giving either the bondholder
and/or the issuer an option to take some action against the other party. The action can involve an
option that gives a right (but not the obligation) to buy or sell an asset at a price often called the
exercise or strike price. The right to buy is called a call option while the right to sell is called a put option.

Give three examples of an embedded option that might be included in a bond issue.

Example one is a callable bond. A bond with a call provision gives the issuer the right to call the issue by
redeeming it as a designated price. Example two is a bond convertible into common stock of the issuing
company. A bond with a convertibility feature gives the lender the right to convert the bond into stock.
Example three is a sinking fund bond. A sinking fund provision gives the issuing company the power to
periodically retire part of the bond issue.

Does an embedded option increase or decrease the risk premium relative to the base interest rate?

An embedded option that works in favor of the issuer increases the risk premium relative to the base
interest rate. An embedded option that works in favor of the borrower decreases the risk premium.
Thus, an embedded option can either increase or decrease the risk premium relative to the base interest
rate depending on whom it favors.

Explain why a financial asset can be viewed as a package of zero-coupon instruments.

A financial asset generates cash flows over time. The value of the asset is the present value of all the
cash flows. Since each cash flow can occur at a different point in time, each cash flow should be valued
in today’s dollar using a discount rate that reflects the required rate of return associated with that time
period. Thus, each cash flow is like a zero-coupon bond where today’s value for the zero-coupon bond is
the discounted value of the zero-coupon’s promised maturity value
What should the price of a 5% four-year Treasury security be?

The price of a 5% four-year Treasure security is the present value of its cash flows. Per $100 par value,
each cash flow is the semiannual coupon payment of $100(0.05 / 2) = $2.50. There will be eight
payments of $2.50 plus the payment of the par value of $100 received at the end of period eight. The
appropriate discount rates for each of the eight cash flows are the eight spot rates that correspond with
each of the eight periods when cash flows are received. The present values of the eight respective cash
flows are: $2.3810, $2.2730, $2.1757, $2.0876, $2.0085, $1.9375, $1.9738, and $1.8169. The sum of
these cash flows is $16.5540. The present value of the $100 par value discounted at the theoretical spot
rate of 4.07% is $72.6768. Thus, the price of a 5% four-year Treasury security should be $16.5540 +
$72.6768 = $89.2308 or about $89.23.

What are the problems with using only on-the-run Treasury issues to construct the theoretical spot
rate curve?

There are two problems with using just the on-the-run issues. First, there is a large gap between some of
the maturities points, which may result in misleading yields for those maturity points when estimated
using the linear interpolation method. Second, the yields for the on-the-run issues may be misleading
because most offer the favorable financing opportunity in the repo market

What actions force a Treasury’s bond price to be valued in the market at the present value of the cash
flows discounted at the Treasury spot rates?

The price of a Treasury security should be equal to the present value of its cash flow where each cash
flow is discounted at the theoretical spot rates. If this does not occur then an arbitrage situation
develops where a large profit can be made with no risk involved. Thus, arbitrage forces a Treasury to be
priced based on spot rates and not the yield curve. The ability of dealers to purchase securities and
create value by stripping forces Treasury securities to be priced based on the theoretical spot rates.

What are the two biased expectations theories about the term structure of interest rates?

The two biased expectations theories are the liquidity theory and the preferred habitat theory. They are
considered “biased” because they argue that factors, other than the market’s expectations about future
rates, affect forward rates.

(b) What are the underlying hypotheses of these two theories?

The liquidity theory states that investors will hold longer-term maturities if they are offered a long-term
rate higher than the average of expected future rates by a risk premium that is positively related to the
term to maturity.

The preferred habitat theory also adopts the view that the term structure reflects the expectation of the
future path of interest rates as well as a risk premium. However, the preferred habitat theory rejects the
assertion that the risk premium must rise uniformly with maturity.

A client observes that a corporate bond that he is interested in purchasing with a triple A rating has a
benchmark spread that is positive when the benchmark is U.S. Treasuries but negative when the
benchmark is the LIBOR curve. The client asks you why. Provide an explanation.
The LIBOR or swap curve reflects more risk than the U.S. Treasuries benchmark curve which is a default-
free yield curve. In brief, the LIBOR curve reflects inter-bank credit risk. Unlike a country’s government
bond yield curve, the swap curve reflects the credit risk of the counterparty to an interest rate swap.
Thus, this creates the possibility of a large enough credit risk that can explain why the client observes
that a corporate bond with a triple A rating has a negative benchmark spread when the benchmark is
the LIBOR curve.

The following questions are about Treasury Inflation Protected Securities (TIPS).

(a) What is meant by the “real rate”?

In terms of TIPS, the real rate is the coupon rate. The coupon rate is called the “real rate” since it is the
rate that the investor ultimately earns above the inflation rate. The inflation index that the government
has decided to use for the inflation adjustment is the non-seasonally adjusted U.S. City Average All Items
Consumer Price Index for All Urban Consumers (CPI-U)

(b) What is meant by the “inflation-adjusted principal”?

For TIPS, the inflation-adjusted principal is the principal that the Treasury Department will base both the
dollar amount of the coupon payment and the maturity value on. It is adjusted semiannually. Part of the
adjustment for inflation comes in the coupon payment since it is based on the inflation-adjusted
principal. However, the U.S. government has decided to tax the adjustment each year. This feature
reduces the attractiveness of TIPS as investments in accounts of tax-paying entities. Because of the
possibility of disinflation (i.e., price declines), the inflation-adjusted principal at maturity may turn out to
be less than the initial par value.

Suppose that an investor buys a five-year TIP and there is deflation for the entire period. What is the
principal that will be paid by the Department of the Treasury at the maturity date?

With deflation, the inflation-adjusted principal would fall. However, the Treasury has structured TIPS so
that they are redeemed at the greater of the inflation adjusted principal and the initial par value. Thus,
the investor who buys a five-year TIP is promised the original principle amount at the maturity date.

The investor is guaranteed to receive back at least the amount of principal they initially invested, even if
deflation negatively impacts the inflation-adjusted value. This provides some protection to the investor
against the risk of purchasing power loss due to deflation.

What is the purpose of the daily index ratio?

The purpose of the daily index ratio is to help compute an inflation-adjusted principal for a settlement
date. The inflation-adjusted principal is defined in terms of an index ratio, which is the ratio of the
reference CPI for the settlement date to the reference CPI for the issue date. The reference CPI is
calculated with a three-month lag. For example, the reference CPI for May 1 is the CPI-U reported in
February. The U.S. Department of the Treasury publishes and makes available on its Web site
(www.publicdebt.treas.gov) a daily index ratio for an issue.

How is interest income on TIPS treated at the federal income tax level?
For TIPS, the coupon payment is based on the inflation-adjusted principal. The U.S. government taxes
the adjustment each year. This feature reduces the attractiveness of TIPS as investments in accounts of
tax-paying entities.

Shouldn’t the bid yield be less than the ask yield, because the bid yield indicates how much the dealer is
willing to pay and the ask yield is what the dealer is willing to sell the Treasury bill for

The higher bid means a lower price. So the dealer is willing to pay less than would be paid for the lower
ask price.

What is the difference between refunding protection and call protection?

Unlike call protection, refunding protection prevents redemption only from certain sources, namely the
proceeds of other debt issues sold at a lower cost of money. The holder is protected only if interest rates
decline and the borrower can obtain lower-cost money to pay off the debt.

(b)Which protection provides the investor with greater protection that the bonds will be acquired by
the issuer prior to the stated maturity date?

Call protection is much more absolute than refunding protection. Although there may be certain
exceptions to absolute or complete call protection in some cases (such as sinking funds and the
redemption of debt under certain mandatory provisions), it still provides greater assurance against
premature and unwanted redemption than does refunding protection.

(a)What is a sinking fund requirement in a bond issue?

Corporate bond indentures may require the issuer to retire a specified portion of an issue each year.
This is referred to as a sinking fund requirement. This kind of provision for repayment of corporate debt
may be designed to liquidate all of a bond issue by the maturity date, or it may be arranged to pay only a
part of the total by the end of the term. If only a part is paid, the remainder is called a balloon maturity.

(b) “A sinking fund provision in a bond issue benefits the investor.” Do you agree with this statement?

The sinking fund provision does not give investors complete call protection because debt is being
retired periodically. This could be disadvantageous if interest rates fall. However, the purpose of the
sinking fund provision is to reduce credit risk. This is advantageous to investors because it lowers the
probability of investors not eventually receiving their interest and principal payments. Thus, it boils
down to the investor’s preference.

What is a payment-in-kind bond?

In an LBO or a recapitalization, the heavy interest payment burden that the corporation assumes places
severe cash flow constraints on the firm. To reduce this burden, firms involved in LBOs and
recapitalizations have issued bonds with deferred coupon structures that permit the issuer to avoid
using cash to make interest payments for a period of three to seven years. There are three types of
deferred coupon structures: deferred-interest bonds, step-up bonds, and payment-in-kind bonds.
Payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the
bondholder a similar bond. The period during which the issuer can make this choice varies from 5 to 10
years.
En el contexto de una adquisición apalancada (LBO) o una recapitalización, la carga financiera resultante
de los pagos de intereses puede generar restricciones significativas en el flujo de efectivo de la empresa.
Para aliviar esta carga, las empresas involucradas en LBOs y recapitalizaciones emiten bonos con
estructuras de cupón diferido. Estas estructuras permiten al emisor posponer los pagos de intereses en
efectivo durante un período específico, que suele ser de tres a siete años.

Existen tres tipos de estructuras de cupón diferido: bonos con intereses diferidos, bonos escalonados y
bonos de pago en especie (PIK). Los bonos PIK ofrecen al emisor la opción de realizar pagos de intereses
en efectivo en una fecha determinada o proporcionar al tenedor del bono un bono similar con la misma
tasa de cupón y un valor nominal igual al monto del pago de intereses. Este período de elección puede
extenderse de 5 a 10 años. Estas estructuras buscan aliviar la presión de los pagos de intereses y brindar
flexibilidad financiera a la empresa en el corto plazo.

(b) An investor who purchases a payment-in-kind bond will find that increased interest rate volatility
will have an adverse economic impact. If interest rates rise substantially, there will be an adverse
consequence. So too will a substantial decline in interest rates have adverse consequences. Why?

In general, increased interest rate volatility causes problems for companies who base projections on
expectations of changes in interest rates. Investors can observe that an increase in interest rates will
cause borrowing rates to increase for companies who go to the debt market to obtain funds. Investors
can also observe the problems that deflation will cause since it becomes more difficult for firm to
increase prices even though they have locked in higher rates of borrowing.

For someone who purchases a payment-in-kind bond (called a PIK bond for short), economic stability is
important since the company issuing payment-in-kind bonds need a stable economic environment.

Do you agree or disagree with the following statement? “Since Rule 144A became effective, all
privately placed issues can be bought and sold in the market.”

One would disagree with the statement because not all privately placed issues are Rule 144A private
placements. Securities privately placed are exempt from the registration with the SEC because they are
issued in transactions that do not involve a public offering. T

Consequently, the private-placement market can be divided into two sectors. First is the traditional
private-placement market, which includes non-144A securities. Second is the market for 144A securities.
For this market privately placed issues can be bought and sold in the market among qualified
institutional buyers.

Do you agree or disagree with the following statement? “Traditionally privately placed issues are now
similar to publicly offered securities.”

While there are now more similarities, significant differences still exist today between the Rule 144A
privately placed issues and publicly offered securities. Rule 144A private placements are now
underwritten by investment bankers on a firm commitment basis, just as with publicly issued bonds. For
underwritten issues, the size of the offering is comparable to that of publicly offered bonds. However,
unlike publicly issued bonds, the issuers of privately placed issues tend to be less well known.
 Borrowers in the publicly issued bond market are typically large corporations. Issuers of privately placed
bonds tend to be mediumsized corporations. Those corporations that borrow from banks tend to be
small corporations.

Explain the various ways in which default rates are quoted.

Various way of quoting default rates exist. For example, consider the high-yield corporate bond market
where default can be common. One measure is the default rate which is the par value of the high-yield
corporate bonds that have defaulted in a given calendar year divided by the total par value outstanding
of high-yield corporate bonds during the year. Besides the default rate, other quotes are weighted price
after default, weighted coupon (as a percentage), and default loss (as a percentage). Rates can also be
reported after adjusting for fallen angels.

What is the difference between a credit rating and recovery rating?

Recovery ratings were developed in response for the market’s need for more information for particular
bond issues than could be supplied by a credit rating. While a credit rating can provide guidance on
recovery if a firm is in default, a recovery rating corresponds to a specific range of recovery values.

While credit ratings provide guidance for the likelihood of default and recovery given default, the
market needed better recovery information for specific bond issues. In response to this need, two
ratings agencies, Standard & Poor’s and Fitch, developed recovery rating systems for corporate bonds.

(a) Do you agree or disagree with the following statement? “Most MTN issues are rated non-
investment grade at the time of offering.”

One would tend to disagree given the nature of most MTNs. Because MTNs are issued with shorter
maturity, ceteris paribus, they have less credit risk than long term bonds, which regularly achieve
investment grade ratings. Thus, there is no inherent reason that MTN issues should be rated non-
investment grade at the time of the offering. Furthermore, borrowers have flexibility in designing MTNs
to satisfy their own needs including need for a lower credit risk.

(b) Do you agree or disagree with the following statement? “Typically, a corporate issuer with an MTN
program will post rates for every maturity range.”

The company issuing MTNs may not desire to sell MTNs for various maturities. Thus, in their offering
schedule, the company will not post rates for every maturity range. Because the maturity range in the
offering rate schedule does not specify a specific maturity date, the investor can choose the final
maturity subject to approval by the issuer. The rate offering schedule can be changed at any time by the
issuer either in response to changing market conditions or because the issuer has raised the desired
amount of funds at a given maturity.

(c) Do you agree or disagree with the following statement? “An offering rate schedule for an MTN
program is fixed for two years after the securities are registered.”

A corporation that wants an MTN program will file a shell registration with the SEC for the offering of
securities. The rate offering schedule that is posted can be changed at any time by the issuer either in
response to changing market conditions or because the issuer has raised the desired amount of funds at
a given maturity. In the latter case, the issuer can either not post a rate for that maturity range or lower
the rate. Thus, one would disagree with the statement that an offering rate schedule for an MTN
program is fixed for two years after the securities are registered.

The rate offering schedule can be changed at any time by the issuer either in response to changing
market conditions or because the issuer has raised the desired amount of funds at a given maturity. In
the latter case, the issuer can either not post a rate for that maturity range or lower the rate.

Why is commercial paper an alternative to short-term bank borrowing for a corporation?

Commercial paper is an alternative to short-term bank borrowing for a corporation because it gives
them another way of borrowing or acquiring funds needed in the immediate future. For companies able
to issue commercial paper, the rate is often below the rate that banks require. More details are given
below. Commercial paper is a short-term unsecured promissory note that is issued in the open market
and that represents the obligation of the issuing corporation.

Corporations now use commercial paper for other purposes such as bridge financing.

Comment on the following statement: “An investor who purchases the mortgage bonds of a
corporation knows that, should the corporation become bankrupt, mortgage bondholders will be paid
in full before the common stockholders receive any proceeds.”

Either real property (using a mortgage) or personal property may be pledged to offer security beyond
the issuer’s general credit standing. A mortgage bond grants the bondholders a lien against the pledged
assets, that is, a legal right to sell the mortgaged property to satisfy unpaid obligations to the
bondholders. In practice, foreclosure and sale of mortgaged property is unusual. Usually in the case of
default, a financial reorganization of the issuer provides for settlement of the debt to bondholders.

"Tanto bienes raíces (mediante una hipoteca) como bienes personales pueden ser empeñados para
ofrecer seguridad más allá de la calificación crediticia general del emisor. Un bono hipotecario otorga a
los tenedores de bonos un derecho de retención sobre los activos empeñados, es decir, un derecho legal
para vender la propiedad hipotecada para satisfacer las obligaciones impagas con los tenedores de
bonos. En la práctica, la ejecución hipotecaria y la venta de la propiedad hipotecada son inusuales. Por
lo general, en caso de incumplimiento, una reorganización financiera del emisor prevé la liquidación de
la deuda con los tenedores de bonos.

Why do U.S. investors who invest in non-U.S. bonds prefer foreign government bonds?

This is because of the low credit risk, the liquidity, and the simplicity of the government markets. While
nongovernment markets (“semi-government,” local government, corporate, and mortgage bond
markets) provide higher yields, they also have greater credit risks, and investors may not be ready to
accept alien credit risks and less liquidity.

“The strongest argument for investing in nondollar bonds is that there are diversification benefits.”

First, there is a theoretical argument which states that diversifying bond investments across countries—
particularly with the currency hedged—reduces risk. This is generally demonstrated using modern
portfolio theory by showing that investors can realize a higher expected return for a given level of risk
(as measured by the standard deviation of return) by adding nondollar bonds in a portfolio containing
U.S. bonds. There is another reason for investing in nondollar bonds that competes with diversification.
For example, a study by Litterman (1992) suggests that while the diversification benefits may not be that
great, a powerful reason for a U.S. investor to invest in nondollar bonds is “the increased opportunities
to find value that multiple markets provide.”

What is the difference between LIBID and LIMEAN?

LIBID (London Interbank Bid Rate) and LIMEAN (London Interbank Mean Rate) are both interbank rates
used in the foreign exchange market. Here's the difference between the two:

LIBID is the bid rate, representing what a bank is willing to pay to attract funds, while LIMEAN is the
average of the bid and ask rates, offering a middle ground between buying and selling rates.

What are the different types of warrants that have been included in Eurobond offerings?

Bonds with attached warrants represent a large part of the Eurobond market. A warrant grants the
owner of the warrant the right to enter into another financial transaction with the issuer if the owner
will benefit as a result of exercising. Most warrants are detachable from the host bond; that is, the
bondholder may detach the warrant from the bond and sell it. The different types of bonds with
warrants include equity warrants, debt warrants, and currency warrants. An equity warrant permits the
warrant owner to buy the common stock of the issuer at a specified price. A debt warrant entitles the
warrant owner to buy additional bonds from the issuer at the same price and yield as the host bond.

Why do rating agencies assign a different rating to the debt of a sovereign entity based on whether
the debt is denominated in a local currency or a foreign currency?

Rating agencies assign different ratings to the debt of a sovereign entity based on whether the debt is
denominated in a local currency or a foreign currency. The reason behind this distinction lies in the risk
considerations associated with each scenario. The rating may vary due to factors such as the economic
stability of the issuing country, the ability to repay debt in a specific currency, and the potential for
currency fluctuations, among others. In summary, the currency in which the debt is issued can impact
the credit risk assessment by rating agencies.

What is the single most important leading indicator according to Standard & Poor’s in assessing a
sovereign entities debt?

The single most important leading indicator according to S&P is the rate of inflation. However, other
factors can also be considered. The key factors looked at by S&P are: stability of political institutions and
degree of popular participation in the political process; economic system and structure; living standards
and degree of social and economic cohesion; fiscal policy and budgetary flexibility; public debt burden
and debt service track record; and, monetary policy and inflation pressures. The areas of analysis with
respect to its external balance sheet are the net public debt, total net external debt, and net external
liabilities.

What is a gilt?

Gilts are bonds issued by the United Kingdom government. It was not until the early 1990s that a liquid
government bond market in Continental Europe developed. The market grew throughout the decade.
However, the Euro government bond market (which excludes the gilts) was characterized as a
fragmented market and, as a result, could not develop the type of liquidity that characterized the U.S.
Treasury market.

What risk associated with the government bonds of emerging countries is not viewed as being present
in industrialized countries?

The financial markets of Latin America, Asia with the exception of Japan, and Eastern Europe are viewed
as emerging markets. Investing in the government bonds of emerging market countries entails
considerably more credit or default risk than investing in the government bonds of major industrialized
countries. In addition to more credit risk, these bonds of emerging countries often are less liquid and
designed to defer payment until the bond mature.

(a) What are Brady bonds?

Brady bonds are essentially a financial solution for governments facing difficulties in repaying large
debts, especially to banks. Picture a scenario where a country has substantial debts that it cannot pay,
primarily owed to banks. Brady bonds provide a creative way to transform these debts into bonds that
can be traded on the market. This approach was first employed between Mexico and the United States,
spearheaded by then-Treasury Secretary Nicholas Brady. Essentially, it's a strategy to assist countries
with debt issues in addressing their obligations more manageably, involving government support and
other international institutions.

(b) What are the two types of Brady bonds?

There are two types of Brady bonds. The first type covers the interest due on these loans (“past-due
interest bonds”). The second type covers the principal amount owed on the bank loans (“principal
bonds”). Principal bonds have maturities at issuance from 25 to 30 years and are bullet bonds. The
principal bonds fall into two categories: par and discount bonds. Par principal bonds have a fixed rate;
discount principal bonds have a floating rate.

(c) Explain whether you agree or disagree with the following statement: “Brady bonds are the
dominant form of emerging market government bonds.”

One would disagree with the statement because Brady bonds are not the dominant form of emerging
market government bonds. The dominant forms are global bonds or Eurobonds. The financial markets of
Latin America, Asia (with the exception of Japan), and Eastern Europe are viewed as emerging markets.
Investing in the government bonds of emerging market countries entails considerably more credit risk
than investing in the government bonds of major industrialized countries. Governments of emerging
market countries issue Brady bonds, Eurobonds, or global bonds.

The amount of Brady bonds is about only 10% of the amount issued by emerging market governments.

What are the two primary factors in determining whether funds will be lent to an applicant for a
mortgage loan? (¿Cuáles son los dos factores principales para determinar si se prestarán fondos a un
solicitante de un préstamo hipotecario?)

A person looking to buy a home and needing to borrow money applies for a mortgage and provides
financial information for a credit evaluation. The two key factors in deciding whether the funds will be
granted are:

Payment-to-Income Ratio (PTI): This assesses the applicant's ability to make monthly payments. A lower
ratio indicates a higher likelihood that the applicant can meet the required payments.

Loan-to-Value Ratio (LTV): This compares the loan amount to the market (or appraised) value of the
property. A lower ratio provides more protection to the lender in case of default and property
repossession.

What is the difference between a cash-out refinancing and a rate-and-term refinancing?

When a lender is evaluating an application from a borrower who is refinancing, the loanto-value ratio
(LTV) is dependent upon the requested amount of the new loan and the market value of the property as
determined by an appraisal. When the loan amount requested exceeds the original loan amount, the
transaction is referred to as a cash-outrefinancing. If instead, there is financing where the loan balance
remains unchanged, the transaction is said to be a rate-and-term refinancing or no-cash refinancing.
That is, the purpose of refinancing the loan is to either obtain a better note rate or change the term of
the loan.

What is the difference between a prime loan and a subprime loan?

A loan that is originated where the borrower is viewed to have a high credit quality is classified as a
prime loan. A loan that is originated where the borrower is of lower credit quality or where the loan is
not a first lien on the property is classified as a subprime loan.

What will the mortgage balance be at the end of the 360th month assuming no prepayments?

At the end of the 360th month and assuming no prepayments, we know the balance should be zero.

What is a hybrid ARM?

A popular form of an ARM is the hybrid ARM. For this loan type, for a specified number of years (three,
five to seven, and 10 years), the note rate is fixed. At the end of the initial fixed-rate period, the loan
resets in a fashion very similar to that of more traditional ARM loans (al final del período inicial de tasa
fija, el préstamo se restablece de manera muy similar a los préstamos ARM más tradicionales).

a) What is the original LTV of a mortgage loan?

The original LTV of a mortgage loan is the LTV at the time of origination. The LTV is the ratio of the
amount of the loan to the market (or appraised) value of the property. The lower this ratio, the more
protection the lender has if the applicant defaults and the property must be repossessed and sold.

(b) What is the current LTV of a mortgage loan?

The current LTV is the LTV based on the current unpaid mortgage balance and the estimated current
market value of the property.

(c) What is the problem with using the original LTV to assess the likelihood that a seasoned mortgage
will default?
At one time, investors considered only the original LTV in their analysis of credit risk. Because of periods
in which there has been a decline in housing prices, the current LTV has become the focus of attention.
The current LTV is the LTV based on the current unpaid mortgage balance and the estimated current
market value of the property. Specifically, the concern is that a decline in housing prices can result in a
current LTV that is considerably greater than the original

What are the WAC and WAM of a pass-through security?

Weighted Average Coupon Rate (WAC): Imagine you have several mortgages with different interest
rates. WAC is like finding the average of those rates but taking into account how much money each
mortgage represents in the total. If a mortgage is larger, its interest rate has a greater impact on the
average.

Weighted Average Maturity (WAM): Now, think about the amount of time left for these mortgages to
mature. WAM is like finding the average of those remaining periods, but again, considering how much
money each mortgage represents in the total. If a mortgage is larger, its time to maturity has a greater
impact on the average.

b. After origination of a mortgage-backed security, the WAM changes. What measures are used by
Fannie Mae and Freddie Mac to describe the remaining term to maturity of the loans remaining in the
loan pool?

Fannie Mae and Freddie Mac report the remaining number of months to maturity for a loan pool, which
they refer to as weighted average remaining maturity (WARM). Both Fannie Mae and Freddie Mac also
report the weighted average of the number of months since the origination of the security for the loans
in the pool. This measure is called the weighted average loan age (WALA).

Indicate whether you agree or disagree with the following statement: “The PSA prepayment
benchmark is a model for forecasting prepayments for a pass-through security.”

This sentence means that the "PSA prepayment benchmark" is a model used to anticipate or forecast
prepayments in a pass-through security. In other words, it is a tool or reference that helps estimate how
much mortgages in a financial security backed by them will be prepaid in advance.

In general, does a person who buys a call option want prices to go up or down?

A person who buys a call normally wants the underlying stock price to rise. The only exceptions would
be when the call was insurance for a short stock position or when the long call was part of another
strategy such as an option spread. Comprar para vender

Why do most people sell their valuable options rather than exercising them?

Most buyers of options are interested only in the economic value they contain and the potential for
that value to increase. By selling an option you capture that economic value and do not have to incur
the additional commission associated with exercise. By selling the option you also avoid the additional
capital that is required when you exercise a call or put (if you do not already own the stock).

How is it possible for an options contract to disappear without expiring or being exercised?
A contract disappears when two closing transactions are matched by the clearinghouse. Fungibility
means all contracts with identical terms are equivalent, so long and short positions can be netted out: a
“plus” combined with a “minus” gives you a “zero.”

Comment on the following statement: Options are nothing more than a side bet on the direction stock
prices are going to move.

Although some uninformed people believe this, the statement is a gross overgeneralization. Options are
risk management tools that frequently result in reduced rather than increased portfolio risk.

Why do many people feel that buying a put is preferable to selling short shares of the underlying
stock?

If the underlying stock price declines, both the short seller and the put owner can profit. However,
potential losses are large when you sell stock short, as the stock price can rise to any level. If you buy a
put, however, the most you can lose is the option premium. The two strategies have generally similar
potential for gain, but substantially different consequences if the underlying security rises in value.

Suppose someone buys 5 XYZ APR 40 puts and also buys 5 XYZ APR 30 puts. Is this the same as buying
10 XYZ APR 35 puts?

It is not the same. The profit and loss diagrams are different, and the premium for an APR 35 option is
not the average of an APR 30 and an APR 40

Explain how yesterday’s volume for a futures contract could be 20,000 contracts, yet open interest
rose by only 1,484 contracts.

Open interest represents the number of contracts in existence at a point in time. Each of those contracts
may trade several times during the course of the day. Each trade increases the volume statistic, but
need not affect open interest.

A speculator goes long four T-bill contracts at 93.34 and closes them out 3 weeks later at 93.40.
Calculate this person’s gain or loss in dollar terms.

The initial discount was 6.66%; the subsequent discount was 6.60%. Interest rates went down, so the
value of the T-bills went up. This means the speculator who was long the T-bill futures made money

No es lo mismo. Los diagramas de beneficios y pérdidas son diferentes, y la prima de una opción APR 35
no es el promedio de una APR 30 y una APR 40.

Explica cómo el volumen de contratos de futuros podría haber sido de 20,000 contratos ayer, y sin
embargo, el interés abierto aumentó solo en 1,484 contratos.

El interés abierto representa el número de contratos en existencia en un momento dado. Cada uno de
esos contratos puede negociarse varias veces durante el día. Cada operación aumenta la estadística de
volumen, pero no necesariamente afecta al interés abierto.

Un especulador toma posiciones largas en cuatro contratos de T-bill a 93.34 y los cierra tres semanas
después a 93.40. Calcula la ganancia o pérdida de esta persona en términos de dólares.
El descuento inicial fue del 6.66%; el descuento posterior fue del 6.60%. Las tasas de interés bajaron, por
lo que el valor de los T-bills aumentó. Esto significa que el especulador que estaba largo en los futuros
de T-bill obtuvo beneficios.

Which portfolio can be characterized as a bullet portfolio?

In a bullet strategy, the portfolio is constructed so that the maturities of the securities in the portfolio
are highly concentrated at one point on the yield curve. Thus, Portfolio II can be characterized as a bullet
portfolio because the maturities of its securities are concentrated around one maturity (ten years).

(b) Which portfolio can be characterized as a barbell portfolio?

In a barbell strategy, the maturities of the securities included in the portfolio are concentrated at two
extreme maturities. Thus, Portfolio I can be characterized as a barbell portfolio because the maturities
of its securities are concentrated at two extreme maturities (two years and twenty years).

(c) The two portfolios have the same dollar duration; explain whether their performance will be the
same if interest rates change

Even if the yield curve shifts in a parallel fashion due to changes in interest rates, two portfolios with the
same dollar duration will not give the same performance if they have differences in dollar convexity.
Although with all other things equal it is better to have more convexity than less, the market charges for
convexity in the form of a higher priceor a lower yield. But the benefit of the greater convexity depends
on how much yields change.

(d) If they will not perform the same, how would you go about determining which would perform best
assuming that you have a six-month investment horizon?

To determine which portfolio would have the superior performance, we would want to look at the total
return for the six-month investment horizon given expectations about change in yields and how the
yield curve will shift.

Therefore, when a manager wants to position a portfolio based on expectations as to how he might
expect the yield curve to shift, it is imperative to perform total return analysis. The same analysis can be
performed to assess the potential outcome of a ladder strategy

Explain why you agree or disagree with the following statement: “It is always better to have a
portfolio with more convexity than one with less convexity.”

It is not always better to have a portfolio with more convexity than one with less convexity.

Although with all other things equal it is better to have more convexity than less, the market charges for
convexity in the form of a higher price or a lower yield. But the benefit of the greater convexity depends
on how much yields change.

(b) Explain why you agree or disagree with the following statement: “A bullet portfolio will always
outperform a barbell portfolio with the same dollar duration if the yield curve steepens.”

One would disagree with the statement that a bullet portfolio will always outperform a barbell portfolio
with the same dollar duration if the yield curve steepens.” This is because the performance of a bullet
portfolio compared to a barbell portfolio depends on how much the yield curve steepens.
The key point here is that looking at measures such as yield (yield to maturity or some type of portfolio
yield measure), duration, or convexity reveals little about performance over some investment horizon,
because performance depends on the magnitude of the change in yields and how the yield curve shifts.

Trading commodities

- Manufacturers: These economic agents are long in commodities and hedge their risk exposure
by selling futures contracts.
- Commodity users: Buy futures contracts to lock in the price of commodities.
- Speculators: Explore profit opportunities in the futures markets. The agents could assume long
and short positions.

• Tierras de cultivo y madera* Las inversiones en tierras de cultivo son una cobertura contra la inflación,
promueven la diversificación de la cartera y aumentan de precio debido a la escasez. La demanda de
productos agrícolas está respaldada por:

Un aumento de la población

El aumento de los ingresos y cambios en las dietas

El creciente uso de biocombustibles

El valor de las tierras de cultivo aumentó más que el de las tierras de madera. Razón: Los inversores
institucionales se deshicieron de las tierras de madera en los Estados Unidos y algunos otros países para
invertir en tierras de madera fuera de los Estados Unidos o en mercados de capitales.

Mientras haya compradores para una mercancía en particular, es un bien tangible negociable.

• El rendimiento por conveniencia existe debido a la posesión física de un activo.

• Costo de acarreo = Costo de financiamiento + Costo de almacenamiento + Costo de deterioro

Si el precio de los futuros es mayor que el costo de acarreo, un agente podría ejercer la arbitraje de
compra y venta, es decir, comprar más cantidad de la mercancía de la necesaria y vender una cantidad
adicional en los mercados de futuros.

Example: a six-month futures contract on gold. It costs 2% to store gold. The current price of gold is
$1079 and the risk-free rate is 1%. The lease rate to lend gold is 1%.

•F = 1079e(0.01+0.02-0.01)(0.5)
Categorías de contratos de futuros:
- Agrícolas, por ejemplo, trigo, algodón, ganado.
- Metales y petróleo, por ejemplo, platino, cobre, gas natural, petróleo crudo.
- Financieros, por ejemplo, moneda extranjera, índice bursátil, tasa de interés.
- Otros, por ejemplo, electricidad, catástrofe, permuta financiera.