Final Exams

ADM 3351 A
Fixed Income Securities
2 hours and 50 minutes
Fall 2007
Dr. C. Guo
Students Name: (Print legibly)

____________________________

Student Number:

____________________________

Closed-book exam. A calculator is required. A formula sheet is attached at the end.

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be graded and will receive a final exam grade of zero.
Question
1
2
3
4
5
6
7
Total

Credit
20
10
10
10
15
20
15
100

Mark

Question 1 (20 points)

A 6.5% (pass-through rate) 30-year mortgage-pass-through security is already seasoned
with a weighted average maturity (WAM) of 332 months left. The current outstanding
balance of $200,000,000, and the weighted average coupon (WAC) rate is 8%. The
interest rates are quoted as annual percentage rate (APR) based on monthly compounding
assumption. Assume that the prepayment rate is 150 PSA.
Calculate the total cash flow of the security to the investors for the next 2 months. Fill out
the table on the next page. (15 points)
Home owners do not want to be locked in high mortgage rates. Briefly explain why
financial institutions are unwilling to offer fixed rate mortgage for long term (e.g., 30
years), and how this problem has been solved by the federally sponsored agencies
such as Fannie Mae and Freddie Mac. (5 points)

Answer to Question 1:
(a)
Input
Information:
Begin
ning
Balance:
Passthrough rate:
WAC
WAM
(No. of months)
CPR of
150PSA
Converted
values below:

200,00
0,000
0
.065
0
.08
3
32
0
.09

(Monthly compounding)
(Weighted-average-coupon of the asset pool)
(Weighted-average-maturity of the asset pool)

Monthly
rate

Monthly
WAC:

0
.
005416
667
0
.
006666
667

(pass-through-rate/12)

(WAC/12)

(1)
Month

(2)
Outstandin
g
Balance

(3)
SMM

(4)
Mortgage
Payment

(5)
Interest to
Investors

200,000,00
0
198,324,9
63

0.0075562
6
0.007828
42

1,498,366

1,083,333

1,487,04
4

1,074,26
0

(6)
Schedu
led
Princip
al
165,03
2
164,87
7

(7)
Prepay
ment

(8)
Total
Principal

(9)
Cash Flow
to Investors

1,510,0
04
1,551,
280

1,675,037

2,758,370

1,716,158

2,790,418

(b) Financial institutions are unwilling to offer long term fixed rate mortgages because
their sources of funds are usually short-term deposits. Because their businesses are based
on spread between borrowing and lending, they are going to suffer huge losses if the cost
of funds during the life of a mortgage loan exceeds the fixed mortgage rate. However,
there are fixed income investors who are willing to accept lower interest rate if the
general level of the term structure declines. The federal agencies provide funds to
financial institutions by buying their mortgage contracts, then package and sell the
contracts to the end investors. As a result, the home owners get the prepayment options
because the risks are assumed by the end investors, while the financial institutions and the
federal agencies receive fees from providing financial services.
Question 2 (10 points)
In a Collateralized Mortgage Obligations (CMO), a 6.5% fixed-rate tranche with
$60,000,000 principal balance is used to create a floating-rate tranche (floater) with
$40,000,000 balance and an inverse-floating-rate tranche (inverse floater) with
$20,000,000 balance. If the floater receives one-month LIBOR + 1%, what interest rate
should the inverse floater receive? If the floor rate of the inverse floater is 1.5%, what is
the cap rate of the floater?

Answer to Question 2
The floater counts for 2/3 of the total balance and the inverse floater counts for 1/3. The
interest rate of the inverse floater should be

,
where K is such that
.
Hence, K = 17.5%.
The inverse floater hits floor when
.
Solve for
Hence, the cap for the floater is 8% + 1% = 9%.

Question 3 (10 points)

Assume that a CMO has just one Planned Amortization Class (PAC) bond, and one
supporting bond. The PAC bond is created between PSA 90 and PSA 300. Part of the
principal payments are calculated and shown in the following table. Assume that there is a
sufficient supporting bond at the beginning, but it will be exhausted by Month 210. Given
the actual principal payments in the 4th column, fill out the respective principal payments
to this PAC bondholders in the last column, then, explain briefly on your results.

Month

At 90% PSA

At 300% PSA

Actual Principal Principal Payment to

Payment
PAC Bondholder
1,075,931
600,000
508,169
1,279,412
800,000
569,843

1
508,169
2
569,843

(The supporting bond has gone on Month 210)

211
949,282
213,309
212
946033
209,409

349
613,875
12,314
350
612,292
12,008

200,000
300,000

200,000
300,000

Explanation:
For Months 1 and 2, because the actual principal payments are between the PAC window,
and the supporting bond is available, the PAC bondholders will receive the minimum of
the PAC window principal payments, which are under PSA 90.
After the supporting bond is gone, there is no more protection on the PAC bond. Hence,
the PAC bondholders will receive the actual principal payments, i.e., $200,000 on Month
211 and $300,000 on Month 212, respectively.

Question 4 (10 points)

Assume that the yield curve is always flat. The current interest rate level is at 7% (BEY).
The U.S. Federal Reserve has indicated that it will cut interest rate gradually over the next
two years. Based on this information, you have estimated that the interest rate will fall 50
basis points every 6 months for the next 2 years. You have a two-year investment horizon.
You are considering investing in an 8% U.S. Treasury bond which has 20 years to
maturity. What annualized return (in BEY) can you realize over two years if you invest in
this bond?
(Extra writing space on the next page)

Solution:
If investing in the 10% 10-year note,
Year

R(BE
Y)

r(semiann
ual)

# of
years

# of
perio
ds

0.0

0.070

0.035

20.0

40

0.5

0.065

0.033

19.5

39

1.0

0.060

0.030

19.0

38

1.5

0.055

0.028

18.5

37

2.0

0.050

0.025

18.0

36

Horizo
nR

0.082
BEY=
6

0.16
53

Horizon Return = 0.0826 per half-year,

and in BEY, 2*0.0826 = 0.1653.

Coupon
(% p.a.)

Price

110.6
78
116.4
48
122.4
92
128.7
96
135.3
34

Interest

Cum Int

4.000

4.000

4.000

8.130

4.000

12.374

4.000

16.714

Question 5 (15 points)

The current term structure of interest rate is given as par-yield, i.e., Bond equivalent yield
on par valued coupon bonds with maturities greater than 1 year. Some of the zero-coupon
spot rates have been identified (also quoted as BEY).
Calculate the missing spot rates (10 points)
Find the price of a 10% coupon bond with 5 years to maturity (5 points).

Maturity
(Year)
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0

Par-yield
(BEY)
5.250
5.500
5.750
6.000
6.250
6.500
6.750
6.800
7.000
7.100

Spot Rate

6.2822
6.5494
6.8213
6.8694
7.0947
7.2045

(Extra writing space on the next page)

Answer:

Yea
r
0.5
1.0
1.5
2.0
2.5

YT
M
5.2
50
5.5
00
5.7
50
6.0
00
6.2
50

Spot
Rate
5.250
0
5.500
0
5.759
7
6.019
1
6.282
2

100.00
01

100.00
01

100.00
01

100.00
01

100.00
01

100.00
00

5.750

6.000

6.250

6.500

6.750

6.800

1.500

2.000

2.500

3.000

3.500

4.000

2.875

3.000

3.125

3.250

3.375

3.400

2.801

2.923

3.045

3.167

3.289

3.313

2.723

2.842

2.960

3.078

3.197

3.220

94.47
5

2.755

2.870

2.985

3.099

3.122

0.000

91.48
0

2.775

2.887

2.998

3.020

0.000

0.000

88.35
0

2.784

2.891

2.913

99.99
99
7.00
0
4.50
0
3.50
0
3.41
0
3.31
5
3.21
4
3.10
9
2.99
9

100.00
02
7.100
5.000
3.550
3.459
3.363
3.260
3.153
3.041

3.0
3.5
4.0
4.5
5.0

6.5
00
6.7
50
6.8
00
7.0
00
7.1
00

Par-yield
5.25
5.50
5.75
6.00
6.25
6.50
6.75
6.80
7.00
7.10

6.549
4
6.821
3
6.869
4
7.094
7
7.204
5

0.000

0.000

0.000

85.09
9

2.782

2.802

0.000

0.000

0.000

0.000

81.74
5

2.689

0.000

0.000

0.000

0.000

0.000

78.92
1

0.000

0.000

0.000

0.000

0.000

0.000

0.000

0.000

0.000

0.000

0.000

0.000

Spot Rate
5.25
5.50
5.76
6.02
6.28
6.55
6.82
6.87
7.09
7.20

Discount
Factor

10% 5Y
Cashflow

0.974421437
0.947188331
0.918351697
0.888157608
0.856724538
0.824207093
0.790757144
0.763255472
0.730716814
0.701953148

5
5
5
5
5
5
5
5
5
105
Price

2.88
5
2.76
8
2.67
1
75.6
29
0.00
0

PV
4.872107186
4.735941653
4.591758485
4.440788039
4.283622688
4.121035464
3.953785722
3.816277361
3.653584068
73.70508057
112.1739812

2.926
2.807
2.710
2.594
72.68
7

Question 6 (20 points)

Assume all the coupon bonds have just paid out their respective semi-annual interest
payments today. Assume further that all the bonds have a par value of $100 and are
perfectly divisible (i.e., buying or selling any fraction of a bond unit is possible).
You have a fixed liability of $1,000,000 at the end of the fifth year. Assume that you can
only invest in two bonds: Bond 1 carries 10% coupon with 10 years to maturity and Bond
2 carries 13% coupon with 5 years to maturity.
(10 points) The term structure is flat and the yield (expressed as bond-equivalent
yield) is 8 percent. Construct an immunization portfolio today.
(10 points) Assume the term structure shifts to 9% flat in six months, check if you are
able to meet your obligation, then rebalance your portfolio.
(Extra writing space on next page)
Answer:

(b)
Answer:

Question 7 (15 points)

Briefly answer the follwing short questions ( 3 points each) :
1. What is meant by on-the-run Treasuries? List all of the on-the-run Treasury securities.
Answer:
The on-the-run Treasury issues are the most recently auctioned issue of a given maturity.
These issues include the 3-month, 6-month, and 1-year Treasury bills; the 2-year, 5-year,
and 10-year Treasury notes; and the 30-year Treasury bond. Treasury bills are zerocoupon instruments; the notes and the bond are coupon securities.
2 What is TIPS? Suppose that the coupon rate for a TIPS is 3% and an investor has
purchased $10,000 of par value (initial principal) of this issue today and that the anual
inflation rate is 2%. What is the dollar coupon interest that will be paid in cash at the end
of the first six months?
Answer:
The coupon rate for a TIPS is 3%, the annual inflation rate is 2%, and an
investor purchases today $10,000 par value (principal) of this issue. The
semiannual inflation rate is 1% (2% divided by 2). The inflation-adjusted
principal at the end of the first six-month period is found by multiplying the
original par value by one plus the semiannual inflation rate: (1.01)$10,000 =
$1,100. The coupon payment is then 1.5% (one-half the real rate of 3%) The
coupon payment is therefore 0.015($10,100) = $151.50.
3. What is a sinking fund requirement in a bond issue? How does it work?
Answer:
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. Generally, the issuer may
satisfy the sinking fund requirement by either (i) making a cash payment of the face
amount of the bonds to be retired to the corporate trustee, who then calls the bonds for
redemption using a lottery, or (ii) delivering to the trustee bonds purchased in the open
market that have a total face value equal to the amount that must be retired.

4. What does the yield spread between commercial paper and Treasury bills of the same
maturity reflect?
Answer:
In brief, the yield spread between commercial paper and Treasury bills of the same
maturity reflects differences in credit risk, taxability, and liquidity. The commercial paper
rate is higher than that on Treasury bills for the same maturity for three reasons. First,
the investor in commercial paper is exposed to credit risk. Second, interest earned from
investing in Treasury bills is exempt from state and local income taxes. Finally,
commercial paper is less liquid than Treasury bills..

5. The following excerpt is taken from an article titled MERUS to Boost Corporates,
which appeared in the January 27, 1992, issue of BondWeek, p.6:

MERUS Capital Management will increase the allocation to corporates in its

$790 million long investment-grade fixed-income portfolio by $39.5 million over
the next six months to a year, according to George Wood, managing director.
MERUS will add corporates rated single A or higher in the expectation that
spreads will tighten as the economy recovers and that some credits may be
upgraded.
What types of active portfolio strategies is MERUS Capital Management pursuing?
Answer:
MERUS is employing a credit spread strategy. Credit or quality spreads change
because of expected changes in economic prospects. Credit spreads between Treasury
and non-Treasury issues widen in a declining or contracting economy and narrow during
economic expansion (which is MERUSs case).

Formulas:
Standard Coupon bond pricing:
,.
General formula of Present Value of Fixed Income Security Discounted by Spot Rates:
.
Macaulay Duration for coupon bond:
.
In the above formulas, with i being the semiannual coupon interest rate (i.e., one-half of the quoted
annual coupon interest rate), y is the semiannual discount rate, and m is the number of half-years. The
result is in unit of half-years. Divide this result by 2 to convert it to number of years.
Modified Duration = Macaulay Duration / (1+y)
Duration Approximation:
Convexity measure approximation
Approximating the percentage change of bond price:
Duration of bond portfolio:
.
In the following mortgage calculations, where r is the monthly interest rate and m is the number of months.
r = Quoted Mortgage rate / 12.
Monthly Mortgage Payment = Beginning Outstanding Principal/PVIFA(r,m).
Mortgage Balance before refinancing = Old Monthly paymentPVIFA(r,m),
m is the remaining amortization periods (months).
The 100 PSA Conditional prepayment rate (CPR) is calculated as
where t is the number of months elapsed since the origination of the pass-through security.
Single-month-mortality rate .
The floater receives LIBOR + a%, and the inverse floater receives ,
where the principal of the floater is L times of the inverse floater, i.e., the total principal is 1+L, and the
floater counts for L/(1+L).