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Fixed Income Analysis Workbook

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Fixed Income Analysis Workbook FIXED INCOME ANALYSIS WORKBOOK Second Edition Frank J. Fabozzi, PhD, CFA John Wiley & Sons, Inc. Copyright c 2004, 2007 by CFA Institute. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic formats. For more information about Wiley products, visit our Web site at www.wiley.com. ISBN-13 978-0-470-06919-6 ISBN-10 0-470-06919-8 Printed in the United States of America. 10987654321 CONTENTS PART I Learning Outcomes, Summary Overview, and Problems CHAPTER 1 Features of Debt Securities 3 Learning Outcomes 3 Summary Overview 3 Problems 5 CHAPTER 2 Risks Associated with Investing in Bonds 8 Learning Outcomes 8 Summary Overview 9 Problems 11 CHAPTER 3 Overview of Bond Sectors and Instruments 15 Learning Outcomes 15 Summary Overview 16 Problems 19 CHAPTER 4 Understanding Yield Spreads 22 Learning Outcomes 22 Summary Overview 23 Problems 25 CHAPTER 5 Introduction to the Valuation of Debt Securities 29 Learning Outcomes 29 Summary Overview 29 Problems 31 v vi Contents CHAPTER 6 Yield Measures, Spot Rates, and Forward Rates 33 Learning Outcomes 33 Summary Overview 34 Problems 35 CHAPTER 7 Introduction to the Measurement of Interest Rate Risk 41 Learning Outcomes 41 Summary Overview 42 Problems 44 CHAPTER 8 Term Structure and Volatility of Interest Rates 49 Learning Outcomes 49 Summary Overview 49 Problems 52 CHAPTER 9 Valuing Bonds with Embedded Options 55 Learning Outcomes 55 Summary Overview 55 Problems 58 CHAPTER 10 Mortgage-Backed Sector of the Bond Market 63 Learning Outcomes 63 Summary Overview 63 Problems 65 CHAPTER 11 Asset-Backed Sector of the Bond Market 73 Learning Outcomes 73 Summary Overview 73 Problems 78 CHAPTER 12 Valuing Mortgage-Backed and Asset-Backed Securities 83 Learning Outcomes 83 Summary Overview 83 Problems 86 Contents vii CHAPTER 13 Interest Rate Derivative Instruments 92 Learning Outcomes 92 Summary Overview 92 Problems 94 CHAPTER 14 Valuation of Interest Rate Derivative Instruments 98 Learning Outcomes 98 Summary Overview 99 Problems 100 CHAPTER 15 General Principles of Credit Analysis 106 Learning Outcomes 106 Summary Overview 107 Problems 109 CHAPTER 16 Introduction to Bond Portfolio Management 114 Learning Outcomes 114 Summary Overview 114 Problems 116 CHAPTER 17 Measuring a Portfolio’s Risk Profile 119 Learning Outcomes 119 Summary Overview 120 Problems 122 CHAPTER 18 Managing Funds Against a Bond Market Index 129 Learning Outcomes 129 Summary Overview 130 Problems 132 CHAPTER 19 Portfolio Immunization and Cash Flow Matching 140 Learning Outcomes 140 Summary Overview 140 Problems 142 viii Contents CHAPTER 20 Relative-Value Methodologies for Global Credit Bond Portfolio Management 144 Learning Outcomes 144 Summary Overview 144 Problems 146 CHAPTER 21 International Bond Portfolio Management 151 Learning Outcomes 151 Summary Overview 152 Problems 155 CHAPTER 22 Controlling Interest Rate Risk with Derivatives 159 Learning Outcomes 159 Summary Overview 160 Problems 162 CHAPTER 23 Hedging Mortgage Securities to Capture Relative Value 167 Learning Outcomes 167 Summary Overview 167 Problems 169 CHAPTER 24 Credit Derivatives in Bond Portfolio Management 172 Learning Outcomes 172 Summary Overview 172 Problems 174 PART II Solutions CHAPTER 1 Features of Debt Securities 183 Solutions 183 CHAPTER 2 Risks Associated with Investing in Bonds 186 Solutions 186 Contents ix CHAPTER 3 Overview of Bond Sectors and Instruments 191 Solutions 191 CHAPTER 4 Understanding Yield Spreads 197 Solutions 197 CHAPTER 5 Introduction to the Valuation of Debt Securities 201 Solutions 201 CHAPTER 6 Yield Measures, Spot Rates, and Forward Rates 207 Solutions 207 CHAPTER 7 Introduction to the Measurement of Interest Rate Risk 219 Solutions 219 CHAPTER 8 Term Structure and Volatility of Interest Rates 225 Solutions 225 CHAPTER 9 Valuing Bonds with Embedded Options 231 Solutions 231 CHAPTER 10 Mortgage-Backed Sector of the Bond Market 238 Solutions 238 CHAPTER 11 Asset-Backed Sector of the Bond Market 251 Solutions 251 CHAPTER 12 Valuing Mortgage-Backed and Asset-Backed Securities 258 Solutions 258 x Contents CHAPTER 13 Interest Rate Derivative Instruments 264 Solutions 264 CHAPTER 14 Valuation of Interest Rate Derivative Instruments 270 Solutions 270 CHAPTER 15 General Principles of Credit Analysis 281 Solutions 281 CHAPTER 16 Introduction to Bond Portfolio Management 287 Solutions 287 CHAPTER 17 Measuring a Portfolio’s Risk Profile 290 Solutions 290 CHAPTER 18 Managing Funds Against a Bond Market Index 298 Solutions 298 CHAPTER 19 Portfolio Immunization and Cash Flow Matching 307 Solutions 307 CHAPTER 20 Relative-Value Methodologies for Global Credit Bond Portfolio Management 311 Solutions 311 CHAPTER 21 International Bond Portfolio Management 316 Solutions 316 Contents xi CHAPTER 22 Controlling Interest Rate Risk with Derivatives 324 Solutions 324 CHAPTER 23 Hedging Mortgage Securities to Capture Relative Value 331 Solutions 331 CHAPTER 24 Credit Derivatives in Bond Portfolio Management 335 Solutions 335 About the CFA Program 343 PART I LEARNING OUTCOMES, SUMMARY OVERVIEW, AND PROBLEMS CHAPTER 1 FEATURES OF DEBT SECURITIES LEARNING OUTCOMES After reading Chapter 1 you should be able to: • describe the basic features of a bond (e.g., maturity, par value, coupon rate, bond redeeming provisions, currency denomination, issuer or investor granted options). • describe affirmative and negative covenants. • identify the various coupon rate structures, such as fixed rate coupon bonds, zero-coupon bonds, step-up notes, deferred coupon bonds, floating-rate securities. • describe the structure of floating-rate securities (i.e., the coupon formula, interest rate caps and floors). • define accrued interest, full price, and clean price. • describe the provisions for redeeming bonds, including the distinction between a nonamor- tizing bond and an amortizing bond. • explain the provisions for the early retirement of debt, including call and refunding provisions, prepayment options, and sinking fund provisions. • differentiate between nonrefundable and noncallable bonds. • explain the difference between a regular redemption price and a special redemption price. • identify embedded options (call option, prepayment option, accelerated sinking fund option, put option, and conversion option) and indicate whether each benefits the issuer or the bondholder. • explain the importance of options embedded in a bond issue. • identify the typical method used by institutional investors to finance the purchase of a security (i.e., margin or repurchase agreement). SUMMARY OVERVIEW • A fixed income security is a financial obligation of an entity (the issuer) who promises to pay a specified sum of money at specified future dates. • Fixed income securities fall into two general categories: debt obligations and preferred stock. • The promises of the issuer and the rights of the bondholders are set forth in the indenture. • The par value (principal, face value, redemption value, or maturity value) of a bond is the amount that the issuer agrees to repay the bondholder at or by the maturity date. • Bond prices are quoted as a percentage of par value, with par value equal to 100. 3 4 Learning Outcomes, Summary Overview, and Problems • The interest rate that the issuer agrees to pay each year is called the coupon rate; the coupon is the annual amount of the interest payment and is found by multiplying the par value by the coupon rate. • Zero-coupon bonds do not make periodic coupon payments; the bondholder realizes interest at the maturity date equal to the difference between the maturity value and the pricepaidforthebond. • A floating-rate security is an issue whose coupon rate resets periodically based on some formula; the typical coupon formula is some reference rate plus a quoted margin. • A floating-rate security may have a cap, which sets the maximum coupon rate that will be paid, and/or a floor, which sets the minimum coupon rate that will be paid. • A cap is a disadvantage to the bondholder while a floor is an advantage to the bondholder. • A step-up note is a security whose coupon rate increases over time. • Accrued interest is the amount of interest accrued since the last coupon payment; in the United States (as well as in many countries), the bond buyer must pay the bond seller the accrued interest.
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