Exam Express - CFA L1

Fixed Income
Mind-Map
 CONTENTS

SESSION
1 Fixed-Income Securities

2 Fixed-Income Markets

3 Introduction to Fixed-
Income Valuation

4 Introduction to Asset-
backed Securities
Mind-Map

Mind-Map
Basic Features
Five basic features
Ø Issuer: supranational organizations, sovereign (national)
governments, non-sovereign (local) governments, quasi-
government entities, companies
Ø Maturity: money market, capital market and perpetual
Ø Par value
Ø Coupon rate and frequency: generally semi-annually
Ø Currency denomination: dual-currency bonds and currency
option bonds

5
 Structure of Cash Flow
Principle repayment structure
Ø Bullet Bond/plain vanilla bond
Ø Amortizing bond: full amortization, partially amortization
ü Balloon payment
Ø Sinking fund provision: plans to set aside funds over time to
retire the bond. Less credit risks but more reinvestment risks.
 Structure of Cash Flow
Coupon repayment structure
Ø Floating-Rate notes: Coupon rate = reference rate+ quoted
margin
ü Reference rate reset periodically
Ø Step-up coupon bond: coupon would increase
Ø Credit-linked coupon bond: coupon rate changes when
bond’s credit rating changes.
Ø A payment-in-kind(PIK) coupon bond: coupon is paid in
other financial instruments instead of cash
Ø Deferred coupon bond/split coupon bond: no coupons in
early years but more coupon in later years
 Structure of Cash Flow
Coupon repayment structure (Cont.)
Ø Index-linked bonds: coupon payment is linked to an index
ü Inflation-linked bonds
Ø Equity-linked notes: final payment relies on equity index
 Practice 1
A zero-coupon bond can best be considered a：
A. step-up bond
B. credit linked bond
C. deferred coupon bond

C is correct.
Interest is effectively deferred until maturity. Zero coupon
bond can be thought of as a deferred coupon bond. Credit
linked bond is that coupon changes with credit rating. Step-
up bond refers to coupon increase at specific margin at
specific date.
 Structure of Cash Flow
Contingency provision
Ø Callable bond: issuer has the right to redeem earlier.
ü Callable bonds have a higher yield and lower price than
similar plain vanilla bonds.
ü Putable bonds = plain vanilla bonds - call option value.
Ø Putable bond: investors have the right to redeem earlier.
ü Putable bonds have a lower yield and higher price than
similar plain vanilla bonds.
ü Putable bonds = plain vanilla bonds + put option value.
 Structure of Cash Flow
Contingency provision
Ø A convertible bond: investors have the right to exchange into
stocks.
ü Lower yield, higher price and Convertible bond = straight
bond + call option on equity.
Ø Contingent convertible bonds (Coco): convert to common
equity automatically.
Ø Warrant: an attached option(分离交易).
 Practice 1
Which of the following is not an example of an embedded
option：
A. Warrant
B. Call provision
C. Conversion provision

A is correct.
A warrant is a separate from the bond
 Bond Indenture
Bond indenture (契约)/Trust deed
Ø Legal identity of the bond issuer and its legal form
Ø Source of repayment proceeds
Ø Asset or collateral backing
ü Secured bonds, unsecured bonds, debentures, collateral
trust bonds, equipment trust certificates, Mortgage-backed
securities(MBS)
 Bond Indenture
Bond indenture (契约)/Trust deed
Ø Credit enhancements
ü Internal: subordination, overcollateralization, excess spread
ü External: surety bond, bank guarantee, letter of credit, cash
collateral account
Ø Covenants
ü Affirmative: should DO
ü Negative: can NOT
ü Financial ratio is not necessarily affirmative or negative.
 Practice 1
Relative to positive bond covenants, negative covenants are
most likely:
A. legally prohibited.
B. more expensive for the issuers.
C. enacted at the time of the bond issue.

B is correct.
Negative covenants usually set burdens on issuers, so it is
much more expensive.
 Legal, Regulation and Tax

Eurobonds
Eurobond
market Global bonds
Global bond
markets
National bond Foreign bonds
markets
Domestic bonds
 Practice 1
Kweichow Moutai Co,.Ltd issued in China using RMB is ( ) bond,
in China using Korean Won is ( ) bond, in France using Euro is
( ) bond, in US using Canadian dollar is ( ) bond.
A. domestic
B. foreign
C. Eurobond

A, C, B, C is correct.
 CONTENTS

SESSION
1 Fixed-Income Securities

2 Fixed-Income Markets

3 Introduction to Fixed-
Income Valuation

4 Introduction to Asset-
backed Securities
Mind-Map
 Market Classifications
Market Classifications
Ø Classification by type of issuer: government and government-
related, corporate sector, structured finance sector
Ø Classification by credit quality: investment grade bond, non-
investment grade bond
Ø Classification by maturity: money market security, capital
market security
Ø Classification by type of coupon: fixed-rate bonds, floating-
rate bonds
Ø LIBOR: interbank unsecured interest rate
 Issuance and Trading
Primary bond market
Ø Public offering: underwritten offering (including syndicated
offering), best-efforts
ü Auction (primarily government bond), shelf registration
(one time register with multiple times issuance)
Ø Private placement: only a selected group of investors may
buy the bonds

Secondary bond market

Ø Organized exchange & OTC market

Settlement
 Funding
Funding
Ø Government-related bonds
ü On-the-run: most recently issued bonds
Ø Corporate debts
ü Bank loans (bilateral or syndicated), commercial paper,
corporate notes (medium-term notes, MTN)
Ø Short-term funding to banks
ü Retail deposit: checking accounts, saving accounts, and
money market accounts
ü Wholesale deposit: central bank funds, interbank funds
and large-denomination negotiable certificates of
deposit (CD)
 Funding
Funding (Cont.)
Ø Repurchase agreement (Repo): sale of a security with a
simultaneous agreement by the seller to buy the same
security back from the purchaser at future date.
ü Repurchase price is greater than the selling price and
accounts for the interest charged by the buyer.
ü It could be viewed as collateralized loan.
ü Repo rate: interest rate implied by two prices
ü Repo margin (haircut): difference between the market
value of the collateral security and the value of the loan
ü Reverse repurchase agreement/Reverse repo
 Funding
Funding (Cont.)
Ø Repurchase agreement

Repo rate Repo margin

Longer Repo term Higher Higher
Lower Credit of collateral Higher Higher
Lower Credit of borrower Higher
Collateral not deliver Higher
Collateral high supply low Higher Higher
demand
Higher alternative Higher
interest rate
 Practice 1
Compared to a term repurchase agreement, an overnight
repurchase agreement is most likely to have a:

A. lower repo rate and higher repo margin.

B. higher repo rate and repo margin
C. lower repo rate and repo margin.

C is correct.
Both the repo rate and the repo margin tend to be higher
for longer repo terms. Therefore an overnight repo should
have a lower repo rate and a lower repo margin than a term
(i.e., longer than overnight) repo.
 CONTENTS

SESSION
1 Fixed-Income Securities

2 Fixed-Income Markets

3 Introduction to Fixed-
Income Valuation
4 Introduction to Asset-
backed Securities
Mind-Map
 Pricing Bonds with Single Discount Rate
Yield-to-maturity (YTM)
n
PMTt F
P=  t
+ n
t=1 (1+YTM) (1+YTM)
Ø Three critical assumption for YTM:
üThe investor hold the bond until maturity.
üThe issuer makes full and timely coupon and principal
payments.
üThe investor is able to reinvest coupon payments at YTM.
Ø Bond price at a discount: Coupon rate < Market rate
Ø Bond price at a premium: Coupon rate > Market rate
Ø Bond price at par value: Coupon rate = Market rate
 Pricing Bonds with Single Discount Rate
Yield to call
Ø Yield to call: IRR on cash flows assuming the embedded
call option is exercised.
ü Yield to first call
ü Yield to worst
Matrix pricing
Ø Using comparable bonds to get market discount rate, then
pricing inactively-trading bonds or pre-issuing bonds.
 Pricing Bonds with Single Discount Rate
Floating rate notes (FRNs)
Ø Coupon rate = reference rate +/- quoted margin
ü quoted margin > required margin, FRNs will be priced at
premium.
ü If quoted margin = required margin, FRNs will be priced at
par.
ü If quoted margin < required margin, FRNs will be priced at
discount.
 Practice 1
Which of the following is most likely a limitation of the yield to
maturity measure?
A. It does not reflect the timing of the cash flows.
B. It does not consider the capital gain or loss the investor will
realize by holding the bond to maturity.
C. It assumes coupon payments can be invested at the yield to
maturity.

C is correct.
 Pricing Bonds with Spot Rates and Forward Rates

(1  zA )A  (1  IFRA ,B- A )B- A  (1  zB )B

 Practice 1
The rate, interpreted to be the incremental return for extending
the time-to-maturity of an investment for an additional time
period, is the:
A. add-on rate.
B. forward rate.
C. yield-to-maturity.

B is correct.
The forward rate can be interpreted to be the incremental or
marginal return for extending the time-to-maturity of an
investment for an additional time period.
 Practice 2
Assume the following annual forward rates were calculated
from the yield curve.
Time Period Forward Rate
0y1y 0.50%
1y1y 0.70%
2y1y 1.00%
3y1y 1.50%
4y1y 2.20%
The four-year spot rate is closest to:
A. 0.924%.
B. 1.348%.
C. 1.178%.
Conventions in Fixed Income Market
 Conventions in Fixed Income Market
Yield annualization
Ø Maturing > 1 year: yields are annualized and compounded
Ø Maturing ≤ 1 year: yields are annualized but not compounded
ü Annualized simple rate
Consideration of weekends and holidays
Ø Street convention yield: the IRR neglects weekends and
holidays
Ø True yield: the IRR includes weekends and holidays
Ø Street convention yield is not lower than true yield.
 Conventions in Fixed Income Market
Amortization of discount or premium
Ø Current yield: the sum of the coupon payments received over
the year divided by the flat price.
Ø Simple yield: the sum of annul coupon payment plus straight-
line amortization of discount or premium, divided by the flat
price.
Discount rate or add-on rate
 Days 
PV  FV   1-  DR 
Ø Discount rate:  Year 
Ø Add-on rate: FV
PV 
 Days 
 1   AOR 
 Year 
 Practice 1
Tullett Prebon SITICO, a famous currency dealers in China.
Which price would be used in bond price quotation?
A. flat price.
B. full price.
C. full price plus accrued interest.

A is correct.
Bond dealers usually quote the flat price.
 Yield Spread
Spread
Ø Spread is the difference between the yield-to-maturity and
the benchmark.
Ø G-Spread=YTM(bond)-YTM(treasury).
Ø I-spread/interpolated spread=YTM(bond)-YTM(standard
swap rate)
PMT PMT PMT +FV
PV = +..... +
Ø Zero spread (Z-spread) (1+z1 + Z)1 (1+z2 + Z)2 (1+zN + Z)N

Ø Option-adjusted spread (OAS): yield spread that remove

the influence of embedded option
 Yield Spread
Ø Option-adjusted spread (OAS)
ü OAS = Z-spread - Option value
ü Callable Bond Z Spread > OAS
ü Putable Bond Z Spread < OAS

Spot z-spread: credit,

liquidity and option
risks
“option cost”

Treasury
yield curve
OAS: credit and
liquidity risks
only

Maturity
 Practice 1
An option-adjusted spread (OAS) on a putable bond is the Z-
spread:
A. over the benchmark spot curve.
B. minus the standard swap rate in that currency of the same
tenor.
C. plus the value of the embedded put option expressed in
basis points per year.

C is correct.
OAS of a putable bond is the Z spread plus the option value.
 CONTENTS

SESSION
1 Fixed-Income Securities

2 Fixed-Income Markets

3 Introduction to Fixed-
Income Valuation

4 Introduction to Asset-
backed Securities
Mind-Map

Mind-Map
 Securitization
Ø Special purpose vehicle(SPV)/SPC/SPE is used for specific
purpose of buying financial asset and selling the securities. It
protect the rights of creditors investing in asset backed bond.

Customer Loan Company

Purchase A

A Sell loan to SPC

SPC pay cash to A

Special Buy the ABS

Purpose Investor
Company Cash to SPV
 Securitization
Benefits of securitization
Ø For investors:
ü Higher investment return
ü Higher liquidity
ü Better legal claims on the underlying.
ü Accessibility of asset classes matching their risk, return,
and maturity profiles
Ø For issuers:
ü Lower interest cost
 Practice 1
Carco Motor Company is an automobile manufacturer that is in
the process of creating asset-backed securities (ABS) by utilizing a
pool of loans from cars the company had financed for its
customers and selling them to a separate legal entity. The issuer of
the ABS is also referred to as:

A. The seller
B. A special purpose vehicle
C. The servicer

B is correct.
ABS Map
MBS
 MBS
Residential MBS
Ø Agency RMBS: guaranteed by Ginnie Mae or by Fannie Mae
and Freddie Mac
ü Standard (3 items) of conforming mortgage: maximum
loan size, maximum loan-to-value ratio, loan document
and insurance.
ü MPS (parallel return and risk)
• WAC: weighted average rate of income in the pool
• Pass-through rate: rate of return for investors
• WAM: weighted average maturity
ü Prepayment rate measurement
ü Prepayment risks and solution
ü CMO
Ø Non-Agency RMBS
 MBS
Residential MBS (Cont.)
Ø Agency RMBS
ü Standard (3 items) of conforming mortgage
ü MPS (parallel return and risk)
ü Prepayment rate measurement
• SMM: single monthly rate
• CPR: conditional prepayment rate (annual rate)
• PSA: a monthly series of CPRs by Public Security
Association (PSA)
• Weighted average life (WAL): convention-based
average time to receipt of all principal repayments
ü Prepayment risks and solution
ü CMO
Ø Non-Agency RMBS
 MBS
Residential MBS (Cont.)
Ø Agency RMBS
ü Standard (3 items) of conforming mortgage
ü MPS (parallel return and risk)
ü Prepayment rate measurement
ü Prepayment risks and solution
• Contraction risk: low rate with faster prepayment
• Extension risk: high rate with slower prepayment
• Time tranching: redistribute prepayment risks
• Credit tranching: redistribute credit risks
ü CMO
Ø Non-Agency RMBS
 MBS
Residential MBS (Cont.)
Ø Agency RMBS
ü Standard (3 items) of conforming mortgage
ü MPS (parallel return and risk)
ü Prepayment rate measurement
ü Prepayment risks and solution
ü CMO
• Sequential-pay: high level tranche has less extension
risk but more contraction risk
• PAC: PAC tranche has limited protection against both
extension risk and contraction risk
• Floating rate tranche: constructed by a floater and an
inverse floater
Ø Non-Agency RMBS
 MBS
Residential MBS (Cont.)
Ø Agency RMBS
ü Standard (3 items) of conforming mortgage
ü MPS (parallel return and risk)
ü Prepayment rate measurement
ü Prepayment risks and solution
ü CMO
Ø Non-Agency RMBS
ü Internal credit enhancement: senior/subordinated
structures, overcollateralization, reserve funds
ü External credit enhancement: guarantee by third party
 MBS
Commercial MBS
Ø Commercial mortgage loan is non-recourse loan, so investors
have credit risks.
Ø CMBS investors have considerable call protection, which
differs from RMBS and results in CMBS trading more like
corporate bond.
Ø CMBS investors may face “balloon risk” because many
commercial mortgages are balloon loans.
 ABS
Narrow Sense ABS
Ø Auto loan receivable-backed securities
ü Regular payment + prepayment
ü credit enhancement
Ø Credit card receivable-backed securities
ü Interest is paid periodically, but principal is reinvested
Ø Collateralized debt obligation
ü Collateral manager could buy and sell debt obligations
 Practice 1
Identify three risks associated with investing in mortgage-backed
securities (MBS). Risks associated with investing in MBS are:

A. Interest rate risk, default risk, and prepayment risk.

B. Interest rate risk, contraction risk, and servicing fee risk.
C. Extension risk, credit risk, and downgrade risk.

A is correct.
 Practice 2
CMO tranches provides investors with the ability to choose
between:

A. extension risk and contraction risk.

B. fully amortizing loans and partially amortizing loans.
C. senior bonds and subordinate bonds.

A is correct.
 CONTENTS

SESSION
1 Fixed-Income Risk and
Return

2 Fundamentals of Credit
Analysis
Mind-Map
 Source of Return
Sources of return from investing in a fixed-rate bond
Ø Coupon and principal.
Ø Reinvestment of coupon payments.
Ø Capital gain or loss on the sale of bond prior to maturity.
üCapital gains/losses arise if a bond is sold at a price
above/below its constant-yield price trajectory.
 Duration
Summary of duration application:
Ø Yield duration (Price sensitivity to YTM)

üMacaulay duration
üModified duration
üUncertain future cash flow
üMoney duration
üNo well-defined IRR (YTM) • PVBP (DV01)

Ø Curve duration (Price sensitivity to benchmark yield curve)

üNon-parallel shift üEffective duration

Ø Key rate duration (Sensitivity to yield at specific maturity)

61
 Duration
Ø Macaulay duration: weighted average time to receipt of the
n
bond’s promised payments  t  PVCF t
Macaulay Duration = t=1

 PVCF t
Ø For a perpetuity bond, MacDur =(1+r)/r
Ø Modified duration: providing an linear estimate of the
percentage price change given a change in its YTM.
MacDuration
Modifed Duration =
1+r
%  Price  -ModDur   Yield

P - P
ApproxModDur =
2  ( Yield)  P0
 Duration
Ø Money duration/dollar duration: a measure of the price
change in units of currency given a change in its YTM.
üMoneyDur = ModDur x Price (full)
ü ∆PFull = MoneyDur x ∆Yield
Ø Price value of a basis point (PVBP, DV01): the money change
in full price when its YTM changes by one basis point (0.01%).
P - P
PVBP =
2
üP- and P+ are the full prices calculated by decreasing and
increasing the YTM by 1 basis point.
 Duration
Ø Effective duration:
V- - V+
Effective duration =
2  V0  Δcurve

üMeasures interest rate risk in terms of a parallel shift in the

benchmark yield curve (△Curve).
üUsed for bonds with embedded option due to uncertain
future cash flow and absence of well-defined IRR (YTM).
Ø Key rate duration: useful for measuring the effect of a
nonparallel shift in the yield curve.
 Properties of Duration
Ø Properties of bond duration
ü Longer time-to-maturity usually leads to higher duration.
ü Higher coupon rate leads to lower duration.
ü Higher yield-to-maturity leads to lower duration.
ü Callable (lower rate period) and putable bonds (higher
rate period) have lower duration than similar plain vanilla
bonds.
Ø Bond portfolio duration
üweighted average of the individual bond durations
• Portfolio duration = w1D1 + w2D2 + …… +wnDn
• Limitations: implicitly assume a parallel shift in the yield
curve.
 Practice 1
Which of the following statements about duration is correct? A
bond's:
A. effective duration is a measure of yield duration.
B. modified duration is a measure of curve duration.
C. modified duration cannot be larger than its Macaulay
duration.

C is correct.
A bond's modified duration cannot be larger than its Macaulay
duration. the formula for modified duration is: ModDur
=(MacDur/(1+r)
 Practice 2
Holding all other characteristics the same, the bond exposed to
the greatest level of reinvestment risk is most likely the one
selling at:

A. Discount.
B. Premium.
C. Par.

B is correct.
 Practice 3
One limitation as to why using the average duration of the
bonds in a portfolio does not properly reflect that portfolio's
yield curve risk is that the approach assumes:

A. all the bonds have the same discount rate.

B. a non-parallel shift in the yield curve.
C. a parallel shift in the yield curve.

C is correct.
 Convexity
Ø Convexity is a measure of the curvature of the price-yield
curve.
ü The more curved the worse our duration-based estimates.
ü The convexity adjustment is always positive when
convexity is positive.
Ø Convexity
1 2
%  Price Full
  -ModDur   Yield  +   Con   Yield 
2 
Ø Money convexity

MoneyCon = Convexity  PriceFull

1
ΔPFull = [-MoneyDur  (ΔYield)]+[  MoneyCon  (ΔYield)2 ]
2
 Convexity
Ø Effective convexity
[(PV- ) + (PV+ )] - [2  (PV0 )]
EffCon =
(PV0 )  (ΔCurve)2
Ø A longer maturity, a lower coupon rate or lower yield to
maturity will increase convexity.
Ø For the two bond has same duration, the one with cash flow
more dispersed will have great convexity.
Ø More convex bond outperforms the less convex bond in
both bull (rising price) and bear (falling price) markets.
Ø Callable bonds have negative convexity at low rates period.
Ø Putable bonds have higher positive convexity at high rates
period.
 Practice 1
Suppose a bond's price is expected to increase by 5% if its
market discount rate decreases by 100 basis points. If the
bond's market discount rate increases by 100 basis points, the
bond price is most likely to change by:
A. 5%.
B. less than 5%.
C. more than 5%.
B is correct.
The bond price is most likely to change by less than 5%.
Relationship between bond prices and market discount rate is
not linear. (the convexity effect).
 Interest Rate Risk
Macaulay duration
Ø Duration gap is bond’s Macaulay duration minus investment
horizon.
ü When investment horizon > Macaulay duration (duration
gap < 0)
• Reinvestment risk dominates market price risk.
• Investor's risk is to lower interest rates.
ü When investment horizon = Macaulay duration (duration
gap = 0)
• Reinvestment risk offsets market price risk.
ü When investment horizon < Macaulay duration (duration
gap > 0)
• Market price risk dominates reinvestment risk.
• Investor's risk is to higher interest rates.
 CONTENTS

SESSION
1 Fixed-Income Risk and Return

2 Fundamentals of Credit
Analysis
Mind-Map
 Credit Risk
Credit risk
Ø Expected loss = Default probability x Loss severity
ü Loss severity = 1 – Recovery rate
Ø Spread risk: yield premium to "default-risk free” bonds
üCredit migration risk/downgrade risk
üMarket liquidity risk
Ø Issuer rating: rating for an issuer
Ø Issue rating: rating for a specific bond of issuer
Ø Notching: credit ratings can be moved up or down
 Credit Analysis
Ø Traditional credit analysis: 4Cs analysis
Ø Capacity, collateral, covenant, and character
Ø Yield spread = Credit spread + Liquidity premium
üFor small spread change:
Return impact  -ModDur   Spread
üFor larger spread change:
1 
Return impact   -ModDur   Spread  +   Con   Spread2 
2 
 Credit Analysis
Three kinds of special bonds
Ø High yield debt (junk bond)
ü higher risk of default
ü Equity-like approach to high yield analysis
Ø Sovereign debt: focus on government ability and willingness
Ø Municipal debt
ü GO bonds: unsecured bonds issued with the full-faith and
credit of the issuing government, like sovereign debt.
üRevenue bonds: issued for specific project financing (e.g.
toll roads, bridges, airports).
• Higher risk than GO bonds.
 Practice 1
Using the "Four Cs of Credit Analysis" framework, which of the
following is the least likely factor to be considered under the
category of "capacity"?

A. Industry fundamentals
B. History of fraud or malfeasance
C. Level of competition

B is correct.
It is a description of character.
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