CFA Level 2 Fixed Income 2017

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cn
Brief Introduction
Topic weight:
Study Session 1-2 Ethics & Professional Standards 10 -15%
Fixed Income Study Session 3

Study Session 4
Quantitative Methods
Economics
5 -10%
5 -10%
Level 2 -- 2017 Study Session 5-6

Study Session 7-8
Financial Reporting and Analysis
Corporate Finance
15 -20%
5 -15%
Instructor: Feng
Study Session 9-11 Equity Investment 15 -25%
Study Session 12-13 Fixed Income 10 -20%
Study Session 14 Derivatives 5 -15%
Study Session 15 Alternative Investments 5 -10%
Study Session 16-17 Portfolio Management 5 -10%
Weights: 100%
Brief Introduction Brief Introduction
Content: Content:
Study Session 12: Valuation Concepts Study Session 13: Topics in Fixed Income Analysis
Reading 35: The Term Structure and Interest Rate Reading 37: Valuation and Analysis: Bonds with
Dynamics Embedded Options
Reading 36: The Arbitrage-Free Valuation Framework Reading 38: Credit Analysis Models
Reading 39: Credit Default Swaps

http://finance.gaodun.cn
Brief Introduction Brief Introduction
: :
20162017
Fabozzi, F. J
ISBN: 978-7-5654-0650-8

Brief Introduction

Forward Rate Models & Forward Pricing Models
Spot rate
Forward Rate Models & Forward Pricing The rate of interest on a security that makes a single
Models payment at a future point in time (a.k.a zero-coupon rate
Tasks:
or zero rate).
Describe relationships among spot rates and forward
t=0 t=j t=j+k
rates, and the shape of the yield curve; S(j)
$1 [1+S(j)]j
Describe the forward pricing and forward rate models,
S(j): annualized spot rate for time j.
and calculate forward and spot prices and rates using
Spot curve: the term structure of spot rates, the graph of
those models.
the spot rate versus maturity.
Forward Rate Models & Forward Pricing Models Forward Rate Models & Forward Pricing Models
Forward rate Forward rate models

Forward rate is the rate of interest set today for a single- Forward rate models show how forward rates can be
payment security to be issued at a future date. extrapolated from spot rates.
1 S j 1 f j , k
j k j k
t=0 t=j t=j+k 1 S j k
f(j, k) [1+S(j+k)]j+k
$1 [1+f(j, k)]k
f(j, k): annualized k-year forward rate starting at time j. t=0 t=j t=j+k
Forward curve: the term structure of forward rates, the
[1+S(j)]j [1+f(j, k)]k
graph of the forward rate versus maturity.

Example Spot curve vs. forward curve

The spot rates for three hypothetical zero-coupon bonds If yield curves are upward sloping, forward curves lie
with maturities of one, two, and three years are 9%, 10% above the spot curve.
and 11%. Calculate the forward rate for a one-year zero The later the
issued two years from today. initiation date,
Answer: the higher the
(1 + 0.11)3 = (1 + 0.10)2[1 + f(2,1)] forward curve.
f(2,1) = 13.03%
Yield curves at Jul. 31 st, 2013
Spot curve vs. forward curve (Cont.) Discount factor

If yield curves are downward sloping, forward curves lie The price of a risk-free single-unit payment at time j:
1
below the spot curve. P j = j
1 + S j

The later the
initiation date, t=0 t=j t=j+k
S(j)
the lower the
P(j) $1
forward curves.
Yield curves at Dec. 31 st, 2006

Forward price Forward pricing models

The price at time j years from today for a zero-coupon The forward pricing model describes the valuation of
bond with maturity j+k years and unit principal. forward contracts.
P j+ k
F j,k =
1 P j + k = P jF j, k F j, k =
1 + f j,k
k Pj
P(j+k)
t=0 t=j t=j+k
f(j, k) t=0 t=j t=j+k
F(j,k) $1
P(j) F(j,k)
Forward Rate Models & Forward Pricing Models Summary
Example Importance:
Consider a 2-year loan beginning in 1 year. The 1-year Content:
spot rate is 7% and the 3-year spot rate is 9%. Calculate Spot rates & forward rates;
the forward price of a 2-year bond to be issued in 1 year. Spot curve and forward curve;
Forward rate models & forward pricing models.
Answer:
Exam tips:
F(1,2) = 0.7722 0.9346 = 0.8262. 1;
2spot curveforward curve

Yield and Spread
Yield-to-Maturity (YTM)
Yield and Spread The internal rate of return on the cash flows of a fixed-rate
bond.
Tasks: n
P M Tt F
P= +
Describe relationships among YTM, expected and t= 1 ( 1 + Y T M ) t ( 1 + Y T M )n
realized returns on bonds; YTM is the same as the spot rate for zero-coupon bonds;
Describe bootstrapping; For coupon bonds, if the spot curve is not flat, the YTM
Explain swap rate curve and calculate swap spread; will not be the same as the spot rate;
Describe Z-spread, TED and LiborOIS spreads. YTM is some weighted average of spot rates.
Yield and Spread Yield and Spread
Yield-to-Maturity (Cont.) Expected return vs. Realized Return

Three critical assumptions for YTM: Expected return is the ex-ante return that a bondholder
The investor hold the bond until maturity; expects to earn.
The issuer makes full and timely coupon and principal The YTM is the expected return only if all the three
critical assumptions for YTM are met.
payments;
Realized return is the actual return on the bond during
The bond is option-free and there is no default risk.
the time an investor holds the bond.
The investor is able to reinvest coupon payments at
It is based on actual reinvestment rates and the yield
YTM.
curve at the end of the holding period.

Bootstrapping Example
Using the output of one step as the input of next step. If the YTMs for annual pay bonds trading at par with
Spot rates may be obtained from the par curve by maturity of 1 year, 2 years and 3 years are 1%, 1.25%,
bootstrapping. and 1.5% respectively, compute the 1-year, 2-year, and 3-

year spot rates.
Par rate is the YTM of a bond trading at par;
Par curve is the term structure of par rates: the
graph of par rate versus maturity.

Answer: Swap rate curve
Step 1: S1=1%; Swap rate: the interest rate for the fixed-rate leg of an
Step 2: value the 2-year bond using spot rates: interest rate swap.
100=1.25/(1+1%)+101.25/(1+S 2)2
Swap rate curve (swap curve): the yield curve of swap
=> S2=1.252%;
rate.
Step 3: value the 3-year bond using spot rates:
100=1.5/(1+1%)+1.5/(1+1.252%) 2+101.5/(1+S 3)3
=> S3=1.51%.


Swap rate curve (Cont.) Swap spread
Investors prefer the swap rate curve rather than The amount by which the swap rate exceeds the rate of
government spot curve in bond valuation because:
the on-the-run government security with the same
Swap rates reflect the credit risk of commercial banks
maturity.
rather than governments.
The swap is not regulated by any government, which Swap spread = Swap rate - Government security rate
makes swap rates in different countries more Libor swap curve is the most widely used yield curve
comparable. because it reflects the default risk of most commercial
The swap curve typically has yield quotes at many banks.
maturities.
Z-spread TED spread

The constant spread that would need to be added to the The spread of Libor over the yield on a T-bill with
implied spot curve so that the discounted cash flows of a matching maturity.
bond are equal to its current market price. TED spread is an indicator of perceived credit risk in the
C F1 C F2 C Fn
P r ice general economy.
1 S n Z
n
1 S 1 Z (1 S 2 Z ) 2
An increase/decrease in the TED spread is a sign that
lenders believe the risk of default on interbank loans
is increasing/decreasing.

Yield and Spread Summary

Libor-OIS spread Importance:
The spread of Libor over the overnight indexed swap Content:
(OIS) rate. YTM, expected return and realized return;
An OIS is an interest rate swap in which the periodic Bootstrapping;
floating rate is equal to the geometric average of an Swap curve and swap spread;
overnight index rate over every day of the payment
Z-spread, TED and LiborOIS spreads.
period.
Exam tips:
Considered an indicator of the risk and liquidity of
spreads
money market securities.
Traditional Term Structure Theories
Traditional theories of term structure

Traditional Term Structure Theories Present the underlying economic factors that affect the
shape of the yield curve.
Tasks:
Pure expectations theory
Explain traditional theories of the term structure of
Local Expectations Theory
interest rates;
Liquidity preference theory
Describe the implications of each theory for forward
Segmented market theory
rates and the shape of the yield curve.
Preferred habitat theory

Traditional Term Structure Theories Traditional Term Structure Theories
Unbiased (pure) expectation theory Unbiased expectation theory (Cont.)

This theory suggests that the forward rate is an unbiased Under the unbiased expectations theory:
predictor of the future spot rate. If yield curve is upward sloping, short-term rates are
Underlying assumption: risk neutrality; expected to rise;
This assumption is a significant shortcoming. If yield curve is downward sloping, short-term rates are
Under this theory, bonds of any maturity are perfect expected to fall;
substitutes for one another. If yield curve is flat, short-term rates are expected to
remain constant.
Local expectation theory Liquidity preference theory

This theory assume risk-neutrality only in the short term This theory asserts that liquidity premiums exist to
while incorporate uncertainty in the long term. compensate investors for the added interest rate risk
Under this theory, the expected return for every bond they face when lending long term.
Forward rate = expected spot rate + liquidity premium
over short time periods is the same.
Liquidity premium increase with maturity.
But it is often observed that short-holding-period
Given an expectation of unchanging short-term spot
returns on long-dated bonds do exceed those on
rates, this theory predicts an upward-sloping yield
short-dated bonds.
curve.

Segmented markets theory Preferred habitat theory

Under this theory, each maturity sector can be thought of Similar to the segmented markets theory, but contends
as a segmented market in which yield is determined by that if the premium is large enough, investor will deviate
supply of and demand for loan, and independent from from their preferred maturities or habitats.
the yields in other maturity segments.
Premium is not directly related to maturity;
Consistent with a world where there are asset/liability
Based on the realistic notion that investors will accept
management constraints;
additional risk in return for additional expected returns.
Yields are not a reflection of expected spot rates or
liquidity premiums.
Summary
Importance:
Content: Modern term structure models
5 traditional term structure theories.
Tasks:
Exam tips:
Describe modern term structure models and how

they are used.

Modern Term Structure Models Modern Term Structure Models
Modern term structure models Equilibrium term structure models

Provide quantitatively precise descriptions of how Describe the dynamics of the term structure using
interest rates evolve. fundamental economic variables that are assumed to
Equilibrium term structure models affect interest rates.
The Cox-Ingersoll-Ross model Can be one-factor or multi-factor models.
The Vasicek Model
Arbitrage free models
The Ho-Lee Model
Equilibrium term structure models (Cont.) Cox-Ingersoll-Ross (CIR) model

In the modeling process, restrictions are imposed that CIR model is based on the idea that individuals must
determine his/her optimal trade-off between
allow for the derivation of equilibrium prices for bonds
consumption today and investing and consuming at a
and interest rate options.
later time.
Require the specification of a drift term and the Higher interest rate more investing more capital
assumption of a functional form for interest rate supply lower interest rate; and vice versa.
volatility. Ultimately, interest rates will reach a market
equilibrium rate at which no one needs to borrow or
lend.

CIR model (Cont.) CIR model (Cont.)

Mathematically, the CIR model is as follows: b: long-run value of the short-term interest rate;
d r = a b - r d t + rd z r: the short-term interest rate;
Where: a: a positive parameter for speed of mean reversion
dr: a infinitely small change in short-term interest adjustment, and the higher/lower, the quicker/slower;
rate; : interest rate volatility.
dt: a infinitely small increase in time;
dz: an infinitely small movement in a random walk.

CIR model (Cont.) Vasicek model
The CIR model consist of tow terms: Similar to the CIR model, the Vasicek model captures
Drift term: a b - r dt ; which means the interest rate is
mean reversion:
mean-revert to long term value (b) with speed
dr = a b - r dt + dz
presented by parameter (a), also named deterministic
term; Disadvantages of Vasicek model:
Stochastic term: rdz ; also named volatility term. Does not force interest rates to be non-negative;
r in the stochastic term forces interest rate (r) to be Volatility remains constant over the period of analysis.
non-negative, and assets that higher interest rate will
lead to higher volatility.

Arbitrage free models Ho-Lee model

This models assume bonds trading in the market are The model assumes that the yield curve moves in a way
correctly priced (arbitrage free). that is consistent with a no-arbitrage condition.
The modeling process that determines the term d rt = t d t + d z t
structure is such that the bonds valuation process : a time-dependant drift term.
generates their market prices.
Summary
Importance:
Content: Active Bond Portfolio Management
3 modern term structure models.
Tasks:
Exam tips:
Describe the strategy of riding the yield curve;

Explain the measurement of yield curve risk;
Explain the maturity structure of yield volatilities and
their effect on price volatility.

Active Bond Portfolio Management Active Bond Portfolio Management
Forward rates vs. future spot rates Example

If future spot rates actually evolve as implied by the Assume that one-year spot rate (S 1) is 9% and two-year
current forward curve, the return of bonds of varying spot rate (S2) is 10%, then the implied forward rate f(1,1)
tenor over a same period is always the same. is 11.01%.
1 1 0 %
2
j k
1 S j k f (1 , 1 ) 1 1 .0 1 %
1 S
j
j
1 f j , k
k 1 9 %
The return of one-year zero-coupon bond over the one-
If future spot rates is f(j,k), Sj is always the same.
year holding period is 9%.
Example (Cont.) Example (Cont.)

The price of a two-year zero-coupon bond now (P 0) is: So, the return of two-year zero-coupon bond over the
100
P0 82 . 64 one-year holding period is also 9%.
1 10 %
2
If actual one-year spot rate one year later is current 9 0 .0 8 8 2 .6 4 1 9 %
forward rate f(1,1), the price of the above bond one year
later (P1) is:
100
P1 90 .08
1 11 .01 %


Forward rates vs. future spot rates (Cont.) Riding the yield curve
If future spot rates turn out to be different from implied When a yield curve is upward sloping and the trader
forward rates, the return of bonds of varying tenor over a believes that the yield curve will not change its level and
same period will differ. shape, then buying bonds with a maturity longer than
If future spot rates are expected to be lower/higher,
the investment horizon would provide a total return
investor would perceive the bond to be
greater than the return on a maturity-matching strategy.
undervalued/overvalued.
The bond is valued at successively lower yields and
An active portfolio manager may outperform the overall
higher prices, and then sold before maturity to realize a
market if the manager can predict how future spot rates
will differ from the current implied forward rates. higher return.
Example Example (Cont.)

The following table shows a upward-sloping yield curve Assuming an investor with investment horizon of 5 years
purchase the bond with maturity of 5 years (maturity-
and the prices of a 3% annual-pay coupon bond with
matching strategy):
$100 par value and different maturities.
Annual coupon payment: 3%;
Maturity Yield Price
Capital gain: none.
5 3 100
If the investor purchase the bond with maturity of 30
15 4 88.88
25 5 71.81 years and sell it after 5 years (riding the yield curve):
30 5.5 63.67 Annual coupon payment: 3%;
Capital gain: $71.81 - $63.67 = $8.14.


Summary of duration (review): Managing yield curve risk
Yield duration (price sensitivity to YTM) Yield curve risk: risk to portfolio value arising from
Macaulay duration unanticipated changes in the yield curve.
Uncertain future cash flow Modified duration
Measurement of yield curve risk
No well-defined IRR (YTM) Money duration
PVBP (DV01) Effective duration
Curve duration (price sensitivity to benchmark yield curve) Key rate duration
Non-parallel shift Effective duration Level, steepness, and curvature
Key rate duration (sensitivity to yield at specific maturity)
Effective duration Key rate duration

Measures the bond price sensitivity to a small parallel Measures the bond price sensitivity to a small change in
shift in a benchmark yield curve (Curve). a benchmark yield curve at a specific maturity segment.
P- - P+
EffD u r = Shaping risk: bond price sensitivity to changes in the
2 ( C u rve ) P0
shape of the benchmark yield curve.

Level, steepness, and curvature Level, steepness, and curvature (Cont.)

The yield curve movements can be decomposed into The proportional change in portfolio value resulted from
parallel movement (XL), steepness movement (XS), yield curve movement can be modeled as:
and curvature movements (XC). P
-D L X L - D S X S - D C X C
P
DL, DS, and DC as the sensitivities of portfolio value to
small changes in the level, steepness, and curvature,
respectively.
Active Bond Portfolio Management Summary

Maturity structure of yield volatility Importance:
A representation of the yield volatility of a zero-coupon Content:
bond for every maturity of security. Forward rate vs. future spot rate, and strategy of riding
Typically, short-term rates are more volatile than long- the yield curve;
term rates. Measurement of yield curve risk;
Short-term volatility is most strongly linked to
Maturity structure of yield volatility.
uncertainty regarding monetary policy;
Exam tips:
Long-term volatility is most strongly linked to
Riding the yield curve
uncertainty regarding the real economy and inflation.

Arbitrage-Free Valuation
The law of one price

Arbitrage-Free Valuation
Two goods that are perfect substitutes must sell for the
same current price in the absence of transaction costs.
Tasks:
Otherwise, buying the lower and selling the higher will
Explain arbitrage-free valuation of a fixed-income
earn a riskless profit, and make the two prices converge.
instrument;
Calculate the arbitrage-free value of an option-free, Arbitrage
fixed-rate coupon bond. Trades that earn riskless profits without any net
investment of money.
Arbitrage-Free Valuation Arbitrage-Free Valuation

Arbitrage opportunities Arbitrage-free valuation
There are two types of arbitrage opportunities: An approach to security valuation that determines
Value additivity: the value of the whole must equals
security values that are consistent with the absence of an
the sum of the values of the parts.
arbitrage opportunity.
Stripping: separate the bonds individual cash flows
and trade them as zero-coupon securities;
Reconstitution: recombine the individual zero coupon
securities and reproduce the underlying coupon bond.
Dominance: a financial asset with a risk-free payoff in
the future must have a positive price today.

Arbitrage-Free Valuation Arbitrage-Free Valuation
Arbitrage-free valuation (Cont.) Example:

Viewing any bond as a package of zero-coupon bonds; Suppose that the one-year spot rate is 2%, the two-year
Using spot rates that correspond to the maturities of the spot rate is 3%, and the three-year spot rate is 4%. Then,
zero-coupon bonds to calculate the bond price. the price of a three-year bond that makes a 5% annual
n
P M Tt F coupon payment is:
P= t
+
t= 1 ( 1 + Z t ) ( 1 + Z n )n 5 5 105
P= + + = 1 0 2 .9 6
1 .0 2 1 .0 3 1 .0 4
1 2 3
Zn: spot rate for period n.
If market price is different with the calculated price,
there is an arbitrage opportunity of value additivity.
Summary
Importance:
Content: Binomial interest rate tree
Arbitrage opportunities and arbitrage-free valuation.
Tasks:
Exam tips:
Describe a binomial interest rate tree framework;
spot rates
Describe the process of calibrating a binomial interest
rate tree to match a specific term structure.

Binomial Interest Rate Tree Binomial Interest Rate Tree
Binomial interest rate tree Binomial interest rate tree (Cont.)

The arbitrage-free valuation of bond with spot rates is A interest rate model that assumes interest rates at any
not available for bonds with embedded option, and we point of time (node) have an equal probability of taking
need a valuation approach with binomial interest rate one of two possible values in the next period, an upper
tree. path (U) and a lower path (L).
For bonds with embedded options, changes in future The interest rates at each node are one-period forward
interest rates impact the likelihood the option will be rates corresponding to the nodal period.
exercised and in so doing impact the cash flows.
Binomial Interest Rate Tree Binomial Interest Rate Tree

Binomial interest rate tree (Cont.) Binomial interest rate tree (Cont.)
E.g.: interest rate i 2,LU at node 2 is the rate that will occur The binomial interest rate tree framework is a lognormal
if initial interest i 0 at node 0 follows the lower path to
random walk (lognormal tree) that insures two appealing
node 1, and then follows the upper path to node 2.
2
i2,UU = i2,LU e 2 i2,UU = i2,LL e 4 properties:
i1,U = i1,L e
: standard deviation of interest rate. Non-negativity of interest rates;
i2,UU
higher volatility at higher interest rates.
i1,U
i0 i2,LU
i1,L
i2,LL

Binomial Interest Rate Tree Summary

Binomial interest rate tree (Cont.) Importance:
When calibrating a binomial interest tree, we follow two Content:
rules below: Framework and calibration of binomial interest rate
Choose interest rates fitting to the current yield curve tree.
so that the model produces arbitrage-free values for Exam tips:
the benchmark bonds;
Adjacent forward rates (for the same period) are two

standard deviations apart.
Valuing Option-free Bonds
Backward induction valuation

Valuing Option-Free Bonds
Value bond by moving backward from last period to time
zero.
Tasks:
Bond value at any node:
Describe the backward induction valuation and
Average PV of two possible values from next period;
calculate the value of a bond;
Discount rate is the one-period forward rate at that
Describe pathwise valuation and calculate the value
node.
of a bond.

Valuing Option-free Bonds Valuing Option-free Bonds
Example Answer
Using the interest rate tree below, calculate the value for Step 1: calculate the bond value for up-node at year 1:
1 100 + 7 100 + 7
a 2-year, annual-pay bond with a coupon rate of 7%. V1,U = + = 99.07
2 1.08 1.08
Year 0 Year 1 Year 0 Year 1 Year 2
$100
$99.07
8% $7
$7
3% 8% $100
3% $7
5%
5%
$100
$7

Answer (Cont.) Answer (Cont.)
Step 2: calculate the bond value for down-node at year 1: Step 3: calculate the bond value at year 0:
1 100 + 7 100 + 7 1 99.07 + 7 101.90 + 7
V1,L = + = 101.90 V0 = + = 104.35
2 1.05 1.05 2 1.03 1.03
Year 0 Year 1 Year 2 Year 0 Year 1 Year 2
$100 $100
$99.07 $99.07
$7 $7
$7 $7
8% $100 8%
3% $104.35 $100
$7 3% $7
$101.9 $101.9
$7 $7
5% $100 $100
5%
$7 $7

Pathwise valuation Example

Calculates the present value of a bond for each possible Using the interest rate tree below, calculate the value for
interest rate path and takes the average of these values a 3-year, annual-pay bond with a coupon rate of 3%.
across paths. Year 0 Year 1 Year 2
10.738%
For a binomial interest rate tree with n periods, there
5.778%
will be 2(n-1) unique paths.
3% 7.198%
3.88%
4.825%
Answer Answer (Cont.)

Step 1: find all the interest rate paths according to the Step 2: calculate the bond values for each path and take
the values of these values.
interest rate tree. 3 3 103
Path Year 1 Year 2 Year 3 Value
Value1 = 1.03 + 1.031.05578 + 1.031.05578 1.10738 = 91.03
1 3% 5.778% 10.738% Path Year 1 Year 2 Year 3 Value
2 3% 5.778% 7.198% 1 3% 5.778% 10.738% 91.03
3 3% 3.88% 7.198% 2 3% 5.778% 7.198% 93.85
4 3% 3.88% 4.825% 3 3% 3.88% 7.198% 95.52
4 3% 3.88% 4.825% 97.55
Average: 94.49

Summary
Importance:
Content:
Bonds with Embedded Option
Backward induction valuation;
Tasks:
Pathwise valuation.
Describe fixed-income securities with embedded
Exam tips:
options;

Explain how interest rate volatility, level and shape of
the yield curve affect the value of callable or putable
bond.
Bonds with Embedded Option Bonds with Embedded Option

Basics of bonds with embedded option Basics of bonds with embedded option (Cont.)
Embedded options refers to contingency provisions in the Estate put: allows the heirs of an investor to put the
bonds indenture.
bond back to the issuer upon the death of the investor;
Callable bonds: allows the issuer to benefit from lower
Sinking fund bonds (sinkers): require the issuer to set
interest rates by retiring the bond issue early;
aside funds periodically to retire the bond.
Putable bonds: allows the bondholder to benefit from
higher interest rates by putting back the bonds to the
issuer early.
Extendible bond: allows the bondholder to keep the
bond for a number of years after maturity.


Basics of bonds with embedded option (Cont.) Bonds with embedded option (Cont.)
For a callable bond, the investor is long the straight bond For a putable bond, the investor has a long position in
but short the call option on the bond. both the straight bond and the put option on the bond.
Vcallalbe = Vstraight Vcall Vputalbe = Vstraight + Vput
Interest rate volatility vs. bond value Level of yield curve vs. callable bond value
The value of any embedded option, regardless of the As interest rates decline, the value of the callable bond
type of option, increases with interest rate volatility. Thus: rises less rapidly than the value of the straight bond,
As interest rate volatility increases, the value of the
limiting the upside potential for the investor.
callable bond decreases;
Call option value increases as interest rate decline, the
Note: recall Vcallalbe = Vstraight Vcall
rise of the straight bond value is partially offset by the
As interest rate volatility increases, the value of the
increase in the value of the call option;
putable bond increases.
Note: recall the price-yield curve of callable bond.
Note: recall Vputalbe = Vstraight + Vput

Level of yield curve vs. putable bond value Shape of yield curve vs. callable bond value
As interest rates rise, the value of the putable bond falls As the yield curve moves from being upward sloping, to
less rapidly than the value of the straight bond. flat, to downward sloping, the value of the call option
Put option value increases as interest rates rise, the increases, and the value of the callable bond decreases.
decline of the straight bond value is partially offset by The one-period forward rates become lower and the
the increase in the value of the put option; opportunities to call increase.
Note: recall the price-yield curve of putable bond.
Bonds with Embedded Option Summary
Shape of yield curve vs. putable bond value Importance:

As the yield curve moves from being upward sloping, to Content:
flat, to downward sloping, the value of the put option Basic types of bonds with embedded option;
decreases, and the value of the putable bond decreases. Components of the value of bonds with embedded
The one-period forward rates become lower and the option;
opportunities to put declines. Factors on bond value with embedded option.
Exam tips:

Valuing Bonds with Embedded Option
Valuing bonds with embedded option

Valuing Bonds with Embedded Option
The basic process to value a bond with embedded option
is similar to the valuation of straight bond;
Tasks:
However, the following two points are different:
Describe how the arbitrage-free framework can be
Only binomial interest rate tree model is applicable,
used to value a bond with embedded options;
valuation with spot rates is non-available any more;
Calculate the value of a callable or putable bond from
an interest rate tree.
Valuing Bonds with Embedded Option Valuing Bonds with Embedded Option
Valuing bonds with embedded option (Cont.) Example of callable bond

Need to check at each node to determine whether the Using the interest rate tree below, calculate the value for
embedded option will be exercised or not. a 2-year, 7% annual-pay bond, which has a par value of
Call rule: the value of callable bond is the lower of $100 and callable at $100 at the end of year 1.
the call price and the calculated price if the bond is Year 0 Year 1
not called;
8%
Put rule: the value of putable bond is the higher of
3%
the put price and the calculated price if the bond is
5%
not put.


Step 1: determine the bond value for up-node at year 1: Step 2: determine the bond value for down-node at year 1:
Callable bond value = Min(100, 99.07) = $99.07 Callable bond value = Min(100, 101.9) = $100
$99.07 $100 $100
$100 $7 $99.07 $7
$7 $7
8% $100 8%
3% $100
$7 3% $7
$101.9
5% $100
$100 $7 $100
$7 5% $7
Answer (Cont.) Example of putable bond

Step 3: determine the bond value at year 0: Using the interest rate tree below, calculate the value for
Callable bond value = $103.43 a 2-year, 7% annual-pay bond, which has a par value of
Year 0 Year 1 Year 2
$100 and putable at $100 at the end of year 1.
$100
$99.07 Year 0 Year 1
$7
$7
8% 8%
$103.43 $100
3% $7 3%
$100
$7
$100 5%
5%
$7


Step 1: determine the bond value for up-node at year 1: Step 2: determine the bond value for down-node at year 1:
Putable bond value = Max(100, 99.07) = $100 Putable bond value = Min(100, 101.9) = $101.9
$99.07 $100 $100
$7 $100 $7
$100
$7
$7
8%
8% $100 $100
3% $7 3% $7
$101.9
$100
5%
$100 $7 $100
$7 5% $7
Valuing Bonds with Embedded Option Summary

Answer (Cont.) Importance:
Step 3: determine the bond value at year 0: Content:
Putable bond value = $104.8 Calculation of a callable or putable bond value from
Year 0 Year 1 Year 2 an interest rate tree.
$100
$100 $7 Exam tips:
$7
8% binomial interest rate tree
$104.8 $100
3% $7
$101.9
$7
5% $100
$7

Valuing Risky Bonds with Embedded Option

Valuing risky callable and putable bonds
Valuing Risky Bonds with Embedded Review: Z-spread and option-adjusted spread (OAS):
Option Z-spread: a constant yield spread added to government
Tasks: spot curve that make PV of bond CFs equal to market
Explain the calculation and use of option-adjusted price.
C C C + Par
spreads; PM arket = + + ..... +
(1 + S 1 + Z )1 (1 + S 2 + Z)2 ( 1 + S n + Z )n
Explain how interest rate volatility affects option-
OAS: yield spread that remove the influence of
adjusted spreads. embedded option.
OAS = Z-spread - Option value (%)
Valuing risky callable and putable bonds (Cont.) Valuing risky callable and putable bonds (Cont.)
Review: graph presentation of Z-spread and OAS: When valuing risky bond with the interest rate tree
Rates generated from government spot curve, the model does
Corporate
Bond Yields not produce arbitrage-free price (typically higher than
Z-spread
Option
cost
market price).
OAS Benchmark Spot
Option-adjusted spread (OAS): the constant spread that,
Rate Curve when added to all the one-period forward rates on the
interest rate tree, makes the model price of the bond
Maturity equal to its market price.

Example Valuing risky callable and putable bonds (Cont.)

If the market price of callable bond in the p revious OAS is often used as a measure of value relative to the
example is $102.71, the OAS will be 50 bps. benchmark.

Year 0 Year 1 Year 2 An OAS lower than that for a comparable bond
$98.62 $100
$100 $7 indicates that the bond is likely overpriced.
$7 An OAS larger than that for a comparable bond
$102.71 8%+0.5% $100
$7 indicates that the bond is likely underpriced.
3%+0.5% $101.42
$100 An OAS close to that for a comparable bond indicates
$7 $100
$7
that the bond is likely fairly priced.
5%+0.5%
Interest rate volatility vs. OAS Monte Carlo forward-rate simulation

As interest rate volatility increases, the OAS for the Path dependency: cash flow to be received in a particular
callable bond decreases, and vice versa. period depends on the path followed to reach its current
Higher volatility higher call option value lower level as well as the current level itself.
price for benchmark callable bond lower OAS. E.g.: level of prepayments for MBS is interest rate path
As interest rate volatility increases, the OAS for the dependent.
putable bond increases, and vice versa. Binomial tree backward induction assumes cash flows
Higher volatility higher put option value higher are not path dependent, therefore it cannot value the
price for benchmark putable bond higher OAS. securities with such cash flow.

Valuing Bonds with Embedded Option Summary

Monte Carlo forward-rate simulation (Cont.) Importance:
Monte Carlo forward-rate simulation involves randomly Content:
generating a large number of interest rate paths. Calculation and application of OAS;
A key feature of the Monte Carlo method is that the Interest rate volatility vs. OAS;
underlying cash flows can be path dependent. Monte Carlo forward-rate simulation.
Exam tips:
OAS
Interest Rate Risk of Bonds with Embedded Option
Effective duration
Interest Rate Risk of Bonds with
The sensitivity of the bonds price to a 100 bps parallel
Embedded Option
shift of the benchmark yield curve, typically the
Tasks:
government par curve, assuming no change in the bonds
Calculate and interpret effective duration of a callable
credit spread.
or putable bond;
PV- - PV
Effective duration
Describe one-sided durations and key rate durations; 2 C urve PV0
Compare effective convexities of callable, putable,
and straight bonds.

Interest Rate Risk of Bonds with Embedded Option Interest Rate Risk of Bonds with Embedded Option
Effective duration (Cont.) Effective duration (Cont.)

The process to calculate the PV - and PV+: Step 3: shift the benchmark yield curve up by ( Curve),
Step 1: calculate the implied OAS to the benchmark and calculate the PV + with similar method;
yield curve according to the market price (PV 0); Step 4: calculate the bonds effective duration using the
Step 2: shift the benchmark yield curve down by formula.
(Curve), generate a new interest rate tree, and then
calculate the PV - using the OAS calculated in step 1;
Effective duration (Cont.) Effective duration (Cont.)

Both call and put option will potentially make the bonds The interest rate movements have little impact on
life shorter, so the effective duration of both callable and effective duration of straight bond, but have much
putable bond will be less or equal to that of identical influence on that of callable and putable bonds.
Decrease of interest rate will decrease the effective
straight bond.
duration of callable bond;
Increase of interest rate will decrease the effective
duration of putable bond.
Note: recall the price-yield curves.

Effective duration (Cont.) One-side duration
The effective durations may be misleading when it is
The effective durations when interest rates go up or
calculated by averaging the changes resulting from
shifting the benchmark yield curve up and down by the down.
same amount. One-side up-duration: durations that apply only when
The price sensitivity of bonds with embedded options is interest rates rise.
not symmetrical when the embedded option is in the
One-side down-duration: durations that apply only
money.
The callable bond price has limited upside potential; when interest rates fall.
The putable bond price has limited downside
potential.
Key rate duration/partial duration Effective convexity

The sensitivity of the bonds price to changes in specific The sensitivity of duration to changes in interest rates.
PV- PV 2 PV0
maturities on the benchmark yield curve. Effective convexity
Curve 2 PV0
Help to identify the shaping risk for bonds. Straight bond: always exhibits low positive convexity;
Shaping risk: the sensitivity of bonds price to changes Callable bond:
in the shape of the yield curve (e.g., steepening and When interest rates are high, callable and straight bond
flattening). have similar positive convexity;
When the call option is in the money, the effective
convexity of the callable bond turns negative.

Interest Rate Risk of Bonds with Embedded Option Summary
Effective convexity (Cont.) Importance:

Putable bond: Content:
Always have positive convexity; Effective duration, one-side duration, key rate duration;
When the put option is in the money, the effective Effective convexity.
convexity of the putable bond is higher than straight Exam tips:
bond. effective duration
Note: recall the price-yield curves.
Convertible Bonds
Defining features of convertible bonds

Convertible Bonds Convertible bond: a hybrid security that gives
Tasks: bondholders the right to convert their debt into equity
Describe defining features of a convertible bond; during a pre-determined period (conversion period) at a
Calculate and interpret the components of a pre-determined price (conversion price).
convertible bonds value; Conversion option: a call option on the issuers
Compare risk-return characteristics of a convertible common stock.
bond with straight bond and common stock.

Convertible Bonds Convertible Bonds
Defining features of convertible bonds(Cont.) Analysis of convertible bonds

Conversion value: the value of the bond if it is converted
Conversion ratio: the number of common shares that the
to common shares.
bondholder receives from converting the bonds into Conversion value = Market share price Conversion
shares. ratio
Conversion price = Issue price/Conversion ratio Conversion ratio is fixed but the market share price is
floating, so the conversion value is floating.
Typically, conversion bonds are issued at par value.
Straight value: the value of the bond if it were not
convertible.
The PV of the cash flows
Minimum value: Max(conversion value, straight value)

Analysis of convertible bonds (Cont.) Example
Market conversion price: the price that investors A convertible bond of company A, issued at $900 with
effectively pay for the underlying common share if they
face value of $1000 and coupon rate of 5 percent, can be
buy the convertible bond and then convert it into shares.
Market conversion price converted to 10 common shares, which is traded at $80
= Convertible bond price/Conversion ratio per share. Now, the convertible bond is traded at $850.
Market conversion premium per share Calculate the conversion price, conversion value, market
= Market conversion price - Market share price conversion price, market conversion premium per share,
Market conversion premium ratio market conversion premium ratio.
= Market conversion premium per share/Market share
price

Answer Downside risk

Conversion price = $900/10 = $90; Straight value can be used as a benchmark of the
Conversion value = $80*10 = $800; downside risk of a convertible bond.
Market conversion price = $850/10 =$85; Premium over straight value
Market conversion premium per share = $85 - $80 = $5; = (Convertible bond price/Straight price) - 1
Market conversion premium ratio = $5/$80 = 6.25%;
Upside potential
Depends primarily on the prospects of the underlying
common share.

Valuation equivalence Risk-return characteristics of convertible bonds
The convertible bond can be valued as the equivalence When the underlying share price is well below the
of its component combination: conversion price, the convertible bond exhibits mostly
Convertible bond = Straight bond + Call option on stock bond risk-return characteristics.
Callable convertible bond value Straight value acts as a downside limit.
= Straight bond + Call option on stock - Call option on When the underlying share price is well above the
bond conversion price, the convertible bond exhibits mostly
Putable convertible bond stock risk-return characteristics.
= Straight bond + call option on stock + put option on In between these two extremes, the convertible bond
bond trades like a hybrid instrument.

Summary
Importance:
Content: Measures of Credit Risk
Defining features of a convertible bond;
Tasks:
Components of a convertible bonds value;
Explain probability of default, loss given default,
Comparison of convertible bond with straight bond and
expected loss, and present value of the expected loss;
common stock.
Calculate and interpret the present value of the
Exam tips:
expected loss on a bond;

Compare the credit analysis ABS and corporate debt.
Measures of Credit Risk Measures of Credit Risk
Measures of credit risk Measures of credit risk (Cont.)

Probability of default: the probability that the bond will Expected loss: probability of default loss given default
Present value of expected loss (PVEL) : the largest price
default before maturity.
one would be willing to pay to a third party (e.g., an
Loss given default: the amount of the remaining coupon
insurer) to entirely remove the credit risk of holding the
and principal payments lost in the event of default. bond.
Recovery rate: the percentage of the position received It involves two modifications to the expected loss:
or recovered in default. Adjust the probabilities to account for the risk of the
Loss given default (%) = 100% - Recovery rate (%) cash flows (risk-neutral probability);
Include the time value of money in the calculation.

Measures of credit risk (Cont.) Measures of credit risk (Cont.)

Credit spread: the yield difference between default-free Present value of expected loss (PVEL) is also the
and credit risky zero-coupon bonds (spot rates). difference between the value of a credit-risky bond and
In practice, the true credit spread will consist of both an otherwise identical risk-free bond.
the expected percentage loss and a liquidity risk PVEL can be estimated from credit spread on a risky
premium. bond.
Term structure of credit spread: the relationship of
credit spreads to maturity.

Example Answer
A 6% annual-pay bond, with par value of $1,000, is Time Credit Total Cash
Rf PV(Rf) PV(Risky) PV
maturing in 3 years. Assume all rates are continuously (yrs) spread yield flow
1 2% 1% 3% 60 58.82 58.25 0.57
compounded, using the information in the following
2 3% 2% 5% 60 56.56 54.42 2.14
table, calculate the present value of expected loss for the
3 4% 2% 6% 1060 942.34 890 52.34
payment due in 2 years and the bond.
Total 1057.7 1002.7 55
Time (yrs) Risk-free rate (Rf) Credit spread
The PVEL for payment due in years is:
1 2% 1%
2 3% 2% $56.56 - $54.42 = $2.14
3 4% 2% The PVEL for the bond is: $1057.7 - $ 1002.7 = $ 55

Measures of Credit Risk Summary

ABS vs. Corporate debt Importance:
In the case of a corporate bond, when the issuer defaults, Content:
the cash flows cease and there is a terminal cash flow; Probability of default, loss given default, expected loss;
ABS do not default, but they can lose value as the SPEs PVEL and its calculation;
pool of securitized assets incurs defaults. ABS vs. corporate debt.
The credit risk metric of probability of loss is applied Exam tips:
rather than probability of default.
Credit Models
Credit models
Credit Models Traditional credit models
Tasks: Credit scoring
Explain credit scoring and credit ratings; Credit rating
Explain structural models and reduced form models Newer credit models for corporate credit risk
of corporate credit risk, and their assumptions, Structural models
strengths, and weaknesses. Reduced form models

Credit Models Credit Models
Credit scoring Credit rating

Credit scoring ranks a borrowers credit riskiness. Credit ratings rank the credit risk of a company,
government (sovereign), quasi-government, or ABS.
Provide an ordinal ranking of a borrowers credit risk;
Do not tell the degree to which the credit risk differs
among different ranks.
Used for small businesses and individuals.
Credit rating (Cont.) Credit rating (Cont.)

Strengths of credit ratings
Provide a simple statistic that summarizes a complex
credit analysis of a potential borrower;
Tend to be stable over time, reducing debt market
volatility.

Credit rating (Cont.) Structural models

Weaknesses of credit ratings Structural models were originated to understand the
The stability reduces the correspondence to a debts economics of a companys liabilities and build on the
default probability, and make the rating lag the market; insights of option pricing theory.
Do not depend on business cycle, while default
They are called structural models because they are
probability does;
based on the structure of a companys balance sheet.
The issuer-pays model for compensating credit-rating
agencies has a potential conflict of interest that may
distort the accuracy of credit ratings.
Structural models (Cont.) Structural models (Cont.)

Assumptions of structural models: Call option analogy for equity: holding the companys
Companys assets (A) are traded in a frictionless equity is economically equivalent to owning a European
arbitrage-free market; call option on the companys assets (A) with strike price K
The value of the companys assets has a lognormal
(face value of zero-coupon debt) and maturity T
distribution;
(maturity of debt), because they have the same payoff at
The risk-free interest rate (r) is constant over time;
maturity T.
The company has a simple balance sheet structure with
only one class of simple zero-coupon debt D(K,T) .


At maturity, exercise the call option if A > K, the value Debt option analogy: owning the companys debt is
of both equity and call option is (A-K); economically equivalent to owning a riskless bond, and
At maturity, do not exercise the call option if A < K, the simultaneously selling a European put option on the
value of both equity and call option is zero. assets (A) of the company with strike price K (face value
of zero-coupon debt) and maturity T.

At maturity, exercise the put option if A < K, the value of Under structural models, debt value can be computed as:
both positions is A; D t At N d 1 K e r ( T t ) N ( d 2 )
wherein:
At maturity, do not exercise the put option if A > K, the At 1
ln ( ) r (T t ) 2 (T t )
value of both positions is K. d1 K 2
T t
Vrisky debt = Vrisk-free debt Vput option
d2 d1 s T t
r: continuously compounded risk-free rate;
: standard deviation of asset returns.

Structural models (Cont.) Reduced form models

Strengths: Assumptions of reduced form models:
Provide an option analogy for understanding a The companys zero-coupon bond trades in frictionless
markets that are arbitrage free;
companys default probability and recovery rate;
Risk-free interest rate (r) is stochastic;
Can be estimated using only current market prices.
Economy and recovery rate are stochastic, probability
Weaknesses:
of default is not constant and varies with the state of
Model assumptions of simple balance sheet and traded
economy;
assets are not realistic;
Whether a particular company actually defaults
Estimation procedures do not consider business cycle. depends only on company-specific consideration.

Reduced form models (Cont.) Reduced form models (Cont.)
Under reduced form models, debt value can be Strengths:
computed as: Model inputs are observable, historical estimation
K procedures can be used;
Dt = E

1 + ri Credit risk allowed to fluctuate with business cycle;
wherein: Do not require specification of the companys BS
K = face value of debt; structure.
E = Expectation operation using risk-neutral Weaknesses:
probabilities; Unless the model has been formulated and back tested
ri = Risk-free rate for year i. properly, the hazard rate estimation may not be valid.

Summary
Importance:
Content: Basic Concepts of CDS
Credit scoring and credit rating;
Tasks:
Structural models;
Describe credit default swaps (CDS), and the
Reduced form models.
parameters that define a given CDS product;
Exam tips:
Describe credit events and settlement protocols with
Structural models Reduced form models
respect to CDS.

Basic Concepts of CDS Basic Concepts of CDS
Credit derivative Definition

A derivative instrument in which the underlying is the A derivative contract between two parties, a credit
protection buyer and credit protection seller, in which the
credit quality of a borrower.
buyer makes a series of cash payments to the seller and
Four types of credit derivative: receives a promise of compensation for credit losses
Total return swaps resulting from the default -that is, a pre-defined credit
Credit spread options event - of a third party.
Periodic premium if no
Credit-linked notes default
Protection Protection
Credit default swaps (CDS) buyer Compensation if seller
default occurs


Basic features of CDS Basic features of CDS (Cont.)
Notional amount/principal: the amount of protection Upfront payment/upfront premium: the differential
being purchased. between the credit spread and the standard coupon rate
CDS spread (%): the periodic premium that the buyer of that converted to a present value basis.
a CDS pays to the seller for protection against credit risk.
A credit spread more than the standard coupon rate
CDS coupon rate (%): the periodic premium that the
will result in a cash upfront payment from the
buyer actually pays to the seller. Typically, for
protection buyer to the seller;
standardization:
1% for a CDS on an investment-grade company or A credit spread less than the standard rate would result
index; in a cash upfront payment from the protection seller to
5% for a CDS on a high-yield company or index. buyer.

Single name CDS Single name CDS (Cont.)
A CDS on one specific borrower (reference entity). The payoff of the CDS is determined by the cheapest-to-
Reference obligation: a particular debt instrument
deliver obligation.
issued by the borrower that is the designated
Cheapest-to-deliver obligation: the debt instrument
instrument being covered by CDS.
Usually a senior unsecured obligation (senior CDS); that can be purchased and delivered at the lowest cost
Any debt obligation issued by the borrower that is but has the same seniority as the reference obligation.
pari passu (ranked equivalently in priority of claims)
or higher relative to the reference obligation is
covered.

Index CDS Credit events

A CDS that allows participants to take positions on the The outcome that triggers a payment from the credit
protection seller to the buyer:
credit risk of a combination of borrowers.
Bankruptcy: allows the defaulting party to work with
The notional principle is the sum of the protection on
creditors under the supervision of the court so as to
all the borrowers; avoid full liquidation;
Credit correlation is a key determinant of its value. Failure to pay: a borrower does not make a scheduled
The more correlated the defaults, the more costly it is payment of principal or interest on any outstanding
to purchase the index CDS. obligations after a grace period, without a formal
bankruptcy filing.
Credit events (Cont.) Settlement protocols

Restructuring: the issuer forces its creditors to accept Physical settlement: actual delivery of the debt
terms that are different than those specified in the instrument in exchange for a payment by the credit
original issue. protection seller of the notional amount of the contract.
Reduction or deferral of principal or interest; Reference obligation
Protection Protection
Change in seniority or priority of an obligation; buyer seller
Notional amount
Change in the currency in which principal or interest
is scheduled to be paid.

Basic Concepts of CDS Summary
Settlement protocols (Cont.) Importance:

Cash settlement: the credit protection seller pays cash to Content:
the credit protection buyer. Basic features of CDS;
Payout amount = Payout ratio (%) Notional amount Single name CDS and index CDS;
Payout ratio (%) = 1 - recovery rate (%) Credit events and settlement protocols.
Protection Cash payment Protection Exam tips:

buyer seller
Pricing and Application of CDS

Pricing of CDS
Pricing and Application of CDS Pricing means determining the CDS spread or upfront
payment given a particular coupon rate for a contract.
Tasks: On a present value basis, the sum of the value of CDS
Explain the factors that influence the pricing of CDS; spread, CDS coupon, and the upfront premium should
Describe the use of CDS to manage credit exposures be zero.
and to take advantage of valuation disparities. Upfront premium (%) by buyer
(CDS spread - CDS coupon)Duration of CDS
The lower the CDS coupon rate, the higher the
upfront premium.

Pricing and Application of CDS Pricing and Application of CDS

Pricing of CDS (Cont.) Profit of CDS
Factors that influence the markets pricing of CDS: The value of a CDS may change if the credit quality of the
The higher the probability of default, the higher the reference entity or the credit risk premium in the overall
CDS spread; market change.
Hazard rate: the probability of default given that it
Profit for protection buyer (%)
has not already occurred.
Change in spread (%)Duration of CDS
The higher the loss given default, the higher the CDS
Profit for protection buyer ($)
spread;
Change in spread (%)Duration of CDS Notional
(Expected loss) t = (Hazard rate) t (Loss given default) t
amount($)
Application of CDS Application of CDS (Cont.)

Credit curve: the term structure of credit spread, or the Managing credit exposure: the taking on or shedding of
credit spreads for a range of maturities of a companys credit risk in light of changing expectations and/or
debt . valuation disparities.
Upward-sloping credit curves imply a greater likelihood
Valuation disparity: the focus is on differences in the
of default in later years;
pricing of credit risk in the CDS market relative to that of
Downward-sloping credit curves imply a greater
the underlying bonds.
probability of default in the earlier years.
Downward-sloping curves are less common.


Managing credit exposure Managing credit exposure (Cont.)
Adjustment of credit exposure: increasing/decreasing Curve trade: buying a CDS of one maturity and selling a
credit exposure by selling/buying CDS if having assumed CDS on the same reference entity with a different
too little/much credit risk; maturity.
Naked CDS: buying or selling credit protection without If an investor believes that the credit curve will become
credit exposure to the reference entity; steeper, he can buy a long-term CDS and sell a short-
Long/short trade: taking a long position in one CDS and a term CDS;
short position in another. If an investor believes that the credit curve will become
A bet that the credit position of one entity will improve flatter, he can buy a short-term CDS and sell a long-
relative to that of another. term CDS.
Valuation disparity Valuation disparity (Cont.)

Basis trade: exploit the difference of credit spread Arbitrage trade: buy the cheaper and sell the more
between bond market and CDS market. expensive.
The general idea behind is that any such mispricing will if the cost of the index is not equivalent to the
disappear when the market recognizes the disparity. aggregate cost of the index components;
If a synthetic CDO is not equivalent to the actual CDO.
Synthetic CDO
= Default-free security - CDS (protection seller)

Summary
Importance:
Content:
Pricing and profit of CDS;
Use CDS to manage credit exposure and take
advantage of valuation disparities.
Exam tips:

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Fixed Income Study Session 3

Level 2 -- 2017 Study Session 5-6

Brief Introduction Brief Introduction

Brief Introduction Brief Introduction

Forward Rate Models & Forward Pricing Models

Forward rate Forward rate models

Example Spot curve vs. forward curve

Spot curve vs. forward curve (Cont.) Discount factor

Yield curves at Dec. 31 st, 2006

Forward price Forward pricing models

Forward Rate Models & Forward Pricing Models Summary

Yield and Spread

Yield and Spread Yield and Spread

Yield-to-Maturity (Cont.) Expected return vs. Realized Return

The investor hold the bond until maturity; expects to earn.

Yield and Spread Yield and Spread

bootstrapping. and 1.5% respectively, compute the 1-year, 2-year, and 3-

Yield and Spread Yield and Spread

Yield and Spread Yield and Spread

Yield and Spread Yield and Spread

Z-spread TED spread

Yield and Spread Summary

Traditional Term Structure Theories

Traditional theories of term structure

Traditional Term Structure Theories Traditional Term Structure Theories

Unbiased (pure) expectation theory Unbiased expectation theory (Cont.)

Traditional Term Structure Theories Traditional Term Structure Theories

Local expectation theory Liquidity preference theory

Traditional Term Structure Theories Traditional Term Structure Theories

Segmented markets theory Preferred habitat theory

Modern Term Structure Models Modern Term Structure Models

Modern term structure models Equilibrium term structure models

Modern Term Structure Models Modern Term Structure Models

Equilibrium term structure models (Cont.) Cox-Ingersoll-Ross (CIR) model

Modern Term Structure Models Modern Term Structure Models

CIR model (Cont.) CIR model (Cont.)

Modern Term Structure Models Modern Term Structure Models

Modern Term Structure Models Modern Term Structure Models

Arbitrage free models Ho-Lee model

Active Bond Portfolio Management Active Bond Portfolio Management

Forward rates vs. future spot rates Example

Active Bond Portfolio Management Active Bond Portfolio Management

Example (Cont.) Example (Cont.)

If actual one-year spot rate one year later is current 9 0 .0 8 8 2 .6 4 1 9 %

Active Bond Portfolio Management Active Bond Portfolio Management

Active Bond Portfolio Management Active Bond Portfolio Management

Example Example (Cont.)

Active Bond Portfolio Management Active Bond Portfolio Management

Non-parallel shift Effective duration Level, steepness, and curvature

Key rate duration (sensitivity to yield at specific maturity)

Active Bond Portfolio Management Active Bond Portfolio Management

Effective duration Key rate duration

Active Bond Portfolio Management Active Bond Portfolio Management

Level, steepness, and curvature Level, steepness, and curvature (Cont.)

Active Bond Portfolio Management Summary

The law of one price

Arbitrage-Free Valuation Arbitrage-Free Valuation

Arbitrage-Free Valuation Arbitrage-Free Valuation