LOS
The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.
-----------------
Prescribed reading
“Equity: Concepts and Techniques”
Ch. 6, pp. 256–273, International Investments, 5th edition, Bruno Solnik and Dennis McLeavey (Addison Wesley, 2003)
“Industry Analysis”
Ch. 13, pp. 466–468, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
For points to refresh on Industry analyis based on 7th edition of Reilly and Brown please visit
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch14-points-to-refresh.html
Monday, March 17, 2008
Thursday, March 13, 2008
Reading 59: Company Analysis and Stock Valuation
Prescribed reading
“Company Analysis and Stock Valuation”
Ch. 14, pp. 513–516 and 533–548, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
Visit for points to refresh of this chapter from 7th edition
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch15-points-to-refresh.html
“Company Analysis and Stock Valuation”
Ch. 14, pp. 513–516 and 533–548, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
Visit for points to refresh of this chapter from 7th edition
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch15-points-to-refresh.html
Types of Stocks
59.a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
Company Analysis and Stock Valuation
By evaluating financial performance variable we can identify good companies. But good companies are not necessarily good investments. For finding a good investment, we have to compare the intrinsic value of a stock to its market value.
Stock of a great company may be overpriced and in such as a case the stock of a growth company may not be growth stock.
Growth Companies
Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings. Financial theorists define in more specific terms a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return. So in the definition of financial theorists growth company has a return on investment that is greater than the required rate of return based on its risk measure.
Growth Stocks
Growth stocks are not necessarily shares in growth companies.
A growth stock has a higher rate of return than other stocks with similar risk. Growth stocks give a higher return in comparison to the risk adjusted return that is expected from stocks with similar risk measure.
Superior risk-adjusted rate of return occurs because in the market they are undervalued at that point of time compared to other stocks
Defensive Companies and Stocks
Defensive companies’ future earnings are more likely to withstand an economic downturn. They have low business risk and not excessive financial risk
Defensive stocks are stocks with low or negative systematic risk (beta values). While defensive companies' stocks can be defensive stocks, they are defensive stocks only when their beta value is significantly less than one. So the analyst have to calculate beta value of a stock before declaring any stock as defensive stock.
Cyclical Companies and Stocks
Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity.
Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return. In this case beta value of stocks are significantly higher than one.
Speculative Companies and Stocks
Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain.
Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return. When markets are at historical peaks or stocks are way above their intrinsic values, many stocks may become speculative.
Value versus Growth Investing
In the debate about growth and value investing, both growth and value stocks are have higher risk adjusted returns compared to other stocks.
IN this context, growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued relative the growth of earnings and dividends expected from them.
Value stocks appear to be undervalued for reasons besides earnings growth potential. The growth potential in earnings and dividends is not spectacular in these stocks, and the undervaluation will be because of apprehension that the sales and earnings may decline relative to average companies.
On the basis of quantitative criteria, value stocks (population or all the companies from value stocks are identified) usually have low P/E ratio or low ratios of price to book value. Growth stocks (population or all the companies from which growth stocks are identified) usually have high P/E ratios and high price to book value ratios.
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
Company Analysis and Stock Valuation
By evaluating financial performance variable we can identify good companies. But good companies are not necessarily good investments. For finding a good investment, we have to compare the intrinsic value of a stock to its market value.
Stock of a great company may be overpriced and in such as a case the stock of a growth company may not be growth stock.
Growth Companies
Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings. Financial theorists define in more specific terms a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return. So in the definition of financial theorists growth company has a return on investment that is greater than the required rate of return based on its risk measure.
Growth Stocks
Growth stocks are not necessarily shares in growth companies.
A growth stock has a higher rate of return than other stocks with similar risk. Growth stocks give a higher return in comparison to the risk adjusted return that is expected from stocks with similar risk measure.
Superior risk-adjusted rate of return occurs because in the market they are undervalued at that point of time compared to other stocks
Defensive Companies and Stocks
Defensive companies’ future earnings are more likely to withstand an economic downturn. They have low business risk and not excessive financial risk
Defensive stocks are stocks with low or negative systematic risk (beta values). While defensive companies' stocks can be defensive stocks, they are defensive stocks only when their beta value is significantly less than one. So the analyst have to calculate beta value of a stock before declaring any stock as defensive stock.
Cyclical Companies and Stocks
Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity.
Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return. In this case beta value of stocks are significantly higher than one.
Speculative Companies and Stocks
Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain.
Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return. When markets are at historical peaks or stocks are way above their intrinsic values, many stocks may become speculative.
Value versus Growth Investing
In the debate about growth and value investing, both growth and value stocks are have higher risk adjusted returns compared to other stocks.
IN this context, growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued relative the growth of earnings and dividends expected from them.
Value stocks appear to be undervalued for reasons besides earnings growth potential. The growth potential in earnings and dividends is not spectacular in these stocks, and the undervaluation will be because of apprehension that the sales and earnings may decline relative to average companies.
On the basis of quantitative criteria, value stocks (population or all the companies from value stocks are identified) usually have low P/E ratio or low ratios of price to book value. Growth stocks (population or all the companies from which growth stocks are identified) usually have high P/E ratios and high price to book value ratios.
Reading 60: An Introduction to Security Valuation: Part II
Prescribed reading
“An Introduction to Security Valuation: Part II”
Ch. 11, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
LOS
60a. state the various forms of investment returns;
Visit - for refresher points on this chapter
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch11-points-to-refresh.html
“An Introduction to Security Valuation: Part II”
Ch. 11, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
LOS
60a. state the various forms of investment returns;
Visit - for refresher points on this chapter
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch11-points-to-refresh.html
Earnings Multiplier Model from DDM
c. show how to use the DDM to develop an earnings multiplier model, and explain
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
DDM model in terms of price (when the market is in equilibrium - each stock's is equal to its value determined by DDM model)
P = D1/k-g
Dividing both sides by E1 (Expected Earnings per share)
P/E1 = (D1/E1)/k-g
so the equilibrium P/E1 ratio is determined by D1/E1, k and g and the DDM model can be used to develop the earnings multiplier model also.
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
DDM model in terms of price (when the market is in equilibrium - each stock's is equal to its value determined by DDM model)
P = D1/k-g
Dividing both sides by E1 (Expected Earnings per share)
P/E1 = (D1/E1)/k-g
so the equilibrium P/E1 ratio is determined by D1/E1, k and g and the DDM model can be used to develop the earnings multiplier model also.
Components of Investor's Required Rate of Return
d. explain the components of an investor’s required rate of return (i.e., the real riskfree rate, the expected rate of inflation, and a risk premium) and discuss the risk factors to be assessed in determining a country risk premium for use in estimating the required return for foreign securities;
Five risk components determine risk premiums
Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk
Equity risk premiums are to be derived for each country in which assets are to be acquire for a portfolio.
The five risk components differ substantially between countries:
Business risk varies across countries because it is a function of the variations in the economic activity within a country and also of the operating leverage used by firms within a country. For example, for many years the financing of companies in India was done on the basis of a long debt to equity ratio of 2:1. It is only recently that more conservative debt equity ratios became the norm.
(to be continued)
Five risk components determine risk premiums
Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk
Equity risk premiums are to be derived for each country in which assets are to be acquire for a portfolio.
The five risk components differ substantially between countries:
Business risk varies across countries because it is a function of the variations in the economic activity within a country and also of the operating leverage used by firms within a country. For example, for many years the financing of companies in India was done on the basis of a long debt to equity ratio of 2:1. It is only recently that more conservative debt equity ratios became the norm.
(to be continued)
Reading 61: Introduction to Price Multiple
Prescribed reading:
John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey (AIMR, 2003)
LOS
The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.
John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey (AIMR, 2003)
LOS
The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.
Price to Cash Flow Valuation Multiple
The use of this ratio is also becoming popular.
According to Reilly and Brown, the growth in popularity of this relative valuation technique can be traced to concern over the propensity of some firms to manipulate earnings per share. Cash flow values are generally less prone to manipulation.
Discounted cash flow techniques use only cash flow as the basis for valuation.
According to Reilly and Brown, the growth in popularity of this relative valuation technique can be traced to concern over the propensity of some firms to manipulate earnings per share. Cash flow values are generally less prone to manipulation.
Discounted cash flow techniques use only cash flow as the basis for valuation.
Wednesday, March 12, 2008
STUDY SESSION 14 ANALYSIS OF EQUITY INVESTMENTS:
Industry and Company Analysis
This study session focuses on industry and company analysis and describes the
tools used in forming an opinion about investing in a particular stock or group
of stocks.
This study session begins with the essential tools of equity valuation: the
discounted cash flow technique and the relative valuation approach. These
techniques provide the means to estimate reasonable price for a stock. The
readings on industry analysis are an important element in the valuation process,
providing the top–down context crucial to estimating a company’s potential.
Also addressed is estimating a company’s earnings per share by forecasting
sales and profit margins.
The last reading in this study session focuses on price multiples, one of the
most familiar and widely used tools in estimating the value of a company, and
introduces the application of four commonly used price multiples to valuation.
LEARNING OUTCOMES
Reading 56: An Introduction to Security Valuation: Part I
The candidate should be able to explain the top-down approach, and its
underlying logic, to the security valuation process.
Reading 57: Industry Analysis
The candidate should be able to describe how structural economic changes
(e.g., demographics, technology, politics, and regulation) may affect
industries.
Reading 58: Equity: Concepts and Techniques
The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.
Reading 59: Company Analysis and Stock Valuation
The candidate should be able to:
a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
b. describe and estimate the expected earnings per share (EPS) and earnings
multiplier for a company and use the multiple to make an investment decision
regarding the company.
Reading 60: An Introduction to Security Valuation: Part II
The candidate should be able to:
a. state the various forms of investment returns;
b. calculate and interpret the value both of a preferred stock and a common stock
using the dividend discount model (DDM);
c. show how to use the DDM to develop an earnings multiplier model, and explain
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
d. explain the components of an investor’s required rate of return (i.e., the real riskfree
rate, the expected rate of inflation, and a risk premium) and discuss the risk
factors to be assessed in determining a country risk premium for use in estimating
the required return for foreign securities;
e. estimate the implied dividend growth rate, given the components of the required
return on equity and incorporating the earnings retention rate and current stock
price;
f. describe a process for developing estimated inputs to be used in the DDM,
including the required rate of return and expected growth rate of dividends.
Reading 61: Introduction to Price Multiples
The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.
This study session focuses on industry and company analysis and describes the
tools used in forming an opinion about investing in a particular stock or group
of stocks.
This study session begins with the essential tools of equity valuation: the
discounted cash flow technique and the relative valuation approach. These
techniques provide the means to estimate reasonable price for a stock. The
readings on industry analysis are an important element in the valuation process,
providing the top–down context crucial to estimating a company’s potential.
Also addressed is estimating a company’s earnings per share by forecasting
sales and profit margins.
The last reading in this study session focuses on price multiples, one of the
most familiar and widely used tools in estimating the value of a company, and
introduces the application of four commonly used price multiples to valuation.
LEARNING OUTCOMES
Reading 56: An Introduction to Security Valuation: Part I
The candidate should be able to explain the top-down approach, and its
underlying logic, to the security valuation process.
Reading 57: Industry Analysis
The candidate should be able to describe how structural economic changes
(e.g., demographics, technology, politics, and regulation) may affect
industries.
Reading 58: Equity: Concepts and Techniques
The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.
Reading 59: Company Analysis and Stock Valuation
The candidate should be able to:
a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
b. describe and estimate the expected earnings per share (EPS) and earnings
multiplier for a company and use the multiple to make an investment decision
regarding the company.
Reading 60: An Introduction to Security Valuation: Part II
The candidate should be able to:
a. state the various forms of investment returns;
b. calculate and interpret the value both of a preferred stock and a common stock
using the dividend discount model (DDM);
c. show how to use the DDM to develop an earnings multiplier model, and explain
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
d. explain the components of an investor’s required rate of return (i.e., the real riskfree
rate, the expected rate of inflation, and a risk premium) and discuss the risk
factors to be assessed in determining a country risk premium for use in estimating
the required return for foreign securities;
e. estimate the implied dividend growth rate, given the components of the required
return on equity and incorporating the earnings retention rate and current stock
price;
f. describe a process for developing estimated inputs to be used in the DDM,
including the required rate of return and expected growth rate of dividends.
Reading 61: Introduction to Price Multiples
The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.
STUDY SESSION 15 Fixed Income Investments
STUDY SESSION 15 Fixed Income Investments Basic Concepts
This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.
LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).
Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.
Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.
Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.
This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.
LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).
Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.
Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.
Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.
Tuesday, March 11, 2008
Yield Curve Risk
The yield curve risk is how your portfolio will react with different exposures based on how the yield curve shifts.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa11.asp
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa11.asp
Disadvantages of Callable Securities
h. explain the disadvantages of a callable or prepayable security to an investor;
Call and prepayment risk is concerned with the holders having their bonds paid off earlier than the maturity date. This is due to decreasing marker rates, which cause the issuer to call the bonds. It can also occur when the borrowers in a MBS or ABS refinance or pay off their debt earlier than the stated maturity date.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa9.asp
Call and prepayment risk is concerned with the holders having their bonds paid off earlier than the maturity date. This is due to decreasing marker rates, which cause the issuer to call the bonds. It can also occur when the borrowers in a MBS or ABS refinance or pay off their debt earlier than the stated maturity date.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa9.asp
Reinvestment Risk
i. identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
Reinvestment risk is the risk that the proceeds from the payment of principal and interest, which have to be reinvested at a lower rate than the original investment.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa10.asp
than nonamortizing securities;
Reinvestment risk is the risk that the proceeds from the payment of principal and interest, which have to be reinvested at a lower rate than the original investment.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa10.asp
Credit Risk
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
Default risk: the counterparty or the company that issued debt securities is not in a position to pay the coupon on the debt securities.
Credit spread risk: Spread is the difference between the yield on risky bonds and yield on government securities. If it increases, the prices of risky bonds come down.
Downgrade risk: the quality of the bond as assessed by credit rating agencies may come down. Due to which the spread on the bond will increase and its price decreases
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa12.asp
credit ratings;
Default risk: the counterparty or the company that issued debt securities is not in a position to pay the coupon on the debt securities.
Credit spread risk: Spread is the difference between the yield on risky bonds and yield on government securities. If it increases, the prices of risky bonds come down.
Downgrade risk: the quality of the bond as assessed by credit rating agencies may come down. Due to which the spread on the bond will increase and its price decreases
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa12.asp
Liquidity Risk
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa13.asp
expect to hold a security to the maturity date;
Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa13.asp
Exchange Rate Risk
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
Exchange-rate risk is the risk of receiving less in domestic currency when investing in a bond that is in a different currency denomination than in the investor's home country.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa14.asp
in a foreign currency;
Exchange-rate risk is the risk of receiving less in domestic currency when investing in a bond that is in a different currency denomination than in the investor's home country.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa14.asp
Inflation Risk;
63.m. explain inflation risk;
Also known as Purchasing Power Risk, this risk arises from the decline in value of securities cash flow due to inflation, which is measured in terms of purchasing power.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa16.asp
Also known as Purchasing Power Risk, this risk arises from the decline in value of securities cash flow due to inflation, which is measured in terms of purchasing power.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa16.asp
Reading 65: Understanding Yield Spreads
LOS
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.Federal Reserve);
What is the federal funds market?
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.
The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
What are open market operations?
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.
Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank's reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls.
When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.
What is the discount rate?
Banks also can borrow reserves directly from the Federal Reserve Banks at their "discount windows," and the discount rate is the rate that financially sound banks must pay for this "primary credit." The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board. ("Secondary credit" is offered at higher interest rates and on more restrictive terms to institutions that do not qualify for primary credit.) Since January 2003, the discount rate has been set 100 basis points above the funds rate target, though the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives. At the same time, the (relatively) easy availability of reserves at this rate effectively places a ceiling on the funds rate.
http://www.frbsf.org/publications/federalreserve/monetary/tools.html
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.Federal Reserve);
What is the federal funds market?
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.
The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
What are open market operations?
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.
Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank's reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls.
When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.
What is the discount rate?
Banks also can borrow reserves directly from the Federal Reserve Banks at their "discount windows," and the discount rate is the rate that financially sound banks must pay for this "primary credit." The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board. ("Secondary credit" is offered at higher interest rates and on more restrictive terms to institutions that do not qualify for primary credit.) Since January 2003, the discount rate has been set 100 basis points above the funds rate target, though the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives. At the same time, the (relatively) easy availability of reserves at this rate effectively places a ceiling on the funds rate.
http://www.frbsf.org/publications/federalreserve/monetary/tools.html
Monetary policy in an environment of global financial markets
Reading recommended by the institute for this LOS
Professor Otmar Issing, Launching Workshop of the ECB-CFS Research Network on "Capital Markets and Financial Integration in Europe", Frankfurt am Main, 29 April 2002
Let me first say that it is a great pleasure to open the launching workshop for the Research Network "Capital Markets and Financial Integration in Europe ". Understanding global financial linkages is important, not least from the perspective of a central banker. Further integration of European financial markets is one of the expected benefits from monetary unification. By focusing on these issues, the Network will stimulate research on topics we as policymakers can benefit from.
In my remarks today, I would like to focus on the interaction between the central bank and financial markets. Specifically, I will first address the interdependence between monetary policy making and financial market expectations. Linked to this, I will then discuss some of our experiences of the first years of policy making at the ECB. I will conclude by briefly mentioning the recent changes that we have witnessed in the euro area financial landscape, and touch upon some areas where I believe more research is needed and where your contribution will be particularly valuable.
Let me start by elaborating on the issue of how central bank behaviour affects financial markets. In this respect, financial markets can be seen as a transmission channel of monetary policy. The central bank controls the short-term interest rate, but what matters for consumers' and firms' decisions are market interest rates beyond the direct control of the monetary authority. In this regard, the role of private banks in the transmission of monetary policy has traditionally been strong in the euro area and still plays a dominant role. Increases in liquidity are redistributed to end users through the banking system, at interest rates reflecting both current and expected future refinancing costs for the banks. Therefore, not only the actual situation of banks' balance sheets, but also market expectations about the future course of monetary policy and future inflation become important, since these expectations to a large extent determine those interest rates.
In this context, the monetary policy strategy is crucial. By a clear commitment to price stability, the ECB provides the markets with a reference against which new information can be consistently evaluated. If new information indicates risks to price stability, and markets understand the strategy, expectations will adjust in anticipation of the appropriate reaction of monetary policy. This fosters a smooth implementation of policy, where much of the actual work is done by themarket's adjustment of the term structure of interest rates.
We have structured the strategy of the ECB around two pillars, which can be seen as a means of organising information concerning risks to price stability. The first pillar assigns a prominent role to money, and in this context monetary aggregates are carefully monitored to reveal such threats. Under the second pillar, other macroeconomic and financial variables that contain information about future price developments are analysed. Financial markets, by their inherent forward-looking nature, provide the central bank with valuable information about expected economic developments. Two key markets to be monitored in this context are bond markets and equity markets. The former gives an assessment of expected interest rates through the term structure of interest rates. Bond derivatives can provide important information of the prevailing uncertainty about future interest rate developments. Such information is especially useful when deciding on communication issues, should market expectations deviate too far from the central banks own evaluation of the current circumstances. Equity markets can convey information about future economic activity. They also have a direct role in the transmission of economic shocks, in that changes in consumer's wealth can impact consumption. Traditionally, this effect has been stronger in the US than in Europe . However, recent trends point to an increase in equity holdings by Europeans which might make this channel more important. Increasing globalisation and cross-border ownership seems to have resulted in faster transmission of shocks, perhaps also more oriented towards sectors rather than countries. For example, the recent IT bubble both gained momentum and collapsed simultaneously across a number of countries. This has major impact on our economies because the traditional mitigating effects of trade and diversification do not apply when similar events take place everywhere.
To conclude, under the second pillar the financial markets (as well as other markets such as those for labour and goods) provide the central bank with relevant information about risks to price stability. This, together with the monetary analysis under the first pillar, allows two complementary pictures of the threats to price stability to emerge. In turn, this facilitates cross-checking, stimulates internal discussion, and ultimately, I believe, leads to appropriate monetary policy decisions.
Traditionally, bank lending was the main source of financing economic activities in most countries of the euro area and banks were therefore the main "actors" in the monetary transmission process. However, market based financing has become more important during the last few years. An interesting questions for research is how the evolution of financial markets, for example the continuing expansion of corporate bond markets, will impact the transmission of monetary policy.
Let me turn to the issue of predictability of monetary policy. In the environment I have just described, deliberate attempts to surprise markets would be counterproductive. Rather, implementation of policy will be smoother the more predictable it is. Woodford e.g. emphasises [1] that developments in financial markets have increased the possibilities of the central bank to influence markets, to the extent that it may do so by signalling without actually moving interest rates:
"The more sophisticated markets become, the more scope there will be for communication about even subtle aspects of the bank's decision and reasoning, and it will be desirable for central banks to take advantage of this opportunity."
Communicating with sophisticated financial markets is indeed important. At the same time it is a tricky issue, since the central bank needs to ensure that it guides rather than follows the markets. An eloquent quote by Alan Blinder illustrates the danger of failing to do so:[2] "...Following the markets may be a nice way of unsettling financial surprises, which is a legitimate end in itself. But I fear that it may produce rather poor monetary policy for several reasons. One is that speculative markets tend to run in herds and to overreact to almost everything. Central bankers need to be more cautious and prudent. Another is that financial markets seem extremely susceptible to fads and speculative bubbles which sometimes stray far from fundamentals. Central bankers must innoculate themselves against whimsy and keep their eyes on the fundamentals."
It is of utmost importance that the financial markets believe the stated goals of policy and understand the monetary policy strategy. In time, markets can evaluate the track-record of the ECB relative to the goal of price stability. Adherence to the strategy should gradually enhance the credibility in that markets can interpret monetary policy decisions through the strategy. In this respect, communication with markets is essential to foster a proper understanding of the strategy, and to send clear signals about the central banks current assessment of economic conditions.
It is therefore interesting to study actual developments in market-based indicators in order to gain some insight into how market participants have perceived the predictability and credibility of the ECB. Concentrating initially on the issue of predictability, Gaspar et al. (2001) examine the behaviour of overnight interest rates between the start of 1999 and early 2001[3]. They find that the markets during that period did not appear to make systematic errors with respect to monetary policy announcements. Moreover, Hartmann et al. (2001) find that overnight rates on average moved by less than 5 basis points immediately following monetary policy announcements by the ECB. [4] Finally, if we take a look at the behaviour of implied short-term forward rates at the one-month horizon during the entire period since the introduction of the euro, we see that the majority of ECB interest rate moves have been in line with the expectations of financial market participants. In this regard, the track record of the ECB is comparable to that of other major - and substantially older - central banks, such as the US Federal Reserve or the Bank of England. In my view, this performance is not bad for a young central bank like the ECB.
Of course, one could not claim that the money market has perfectly anticipated policy moves on every single occasion. Sometimes, rapidly changing economic conditions or extraordinary events, such as the September 11 terrorist attacks, require swift and decisive policy action that cannot be fully anticipated in advance. Furthermore, at times the monetary authority has access to information that market participants do not have. This information asymmetry may on rare occasions lead to policy moves that are unexpected by markets. This being said, I again repeat that there can be no interest in the monetary authority deliberately aiming to surprise the financial markets. Such a strategy would merely increase uncertainty in the markets and damage the credibility of the monetary authority.
Turning to this very aspect, taking due account of caveats such as liquidity and risk premia considerations, the market for French index- linked government bonds provides a useful measure of the credibility of monetary policy. The ten-year break-even inflation rate obtained from this market has consistently been in line with the ECB's quantitative definition of price stability, indicating a persistently high degree of credibility. Moreover, there is little evidence that monetary policy moves have generated any systematically higher volatility in the break even rate. This would seem to indicate that markets have perceived ECB monetary policy actions as transparent, in the sense that they do not appear to have induced investors to revise their beliefs about the objective of the ECB. Interestingly, in the last few months, the French treasury has issued new index-linked bonds linked to a measure of euro area HICP, which I am convinced will provide us with additional useful information in this respect.
Consistent with the notion that the monetary policy actions of the ECB have not resulted in increased market uncertainty, there is some evidence that bond market volatility has even declined since the introduction of the euro. For example, since 1999 the implied volatility on 10-year German Bund futures has - apart from a brief surge following September 11 - declined to historically low levels. All these indications from prices of financial instruments, determined by market forces which continuously judge the actions of the ECB, lead me to conclude that our monetary policy has been credible and largely transparent to investors.
This being said, it is also clear to me that we still have much to learn about what determines financial asset prices. Moreover, the nature of financial markets, constantly changing and evolving, adds to the need of widening and deepening our understanding of these markets. This is particularly true for financial markets in the euro area, which arguably have seen the most remarkable pace of change among all developed financial markets over the last few years. For example, the euro area money market has undergone a substantial transformation, including the creation of completely new segments, such as the EONIA swap market. Similarly, the bond market has evolved considerably, with very rapid growth of the corporate bond market segment over the last few years and a sizeable expansion of the international issuance of euro-denominated bonds.
No doubt, the introduction of the single currency and a common monetary policy framework acted as a powerful catalyst in bringing about many of the changes to the euro area financial landscape that we have witnessed in recent years. However, we still need to better understand the exact mechanisms which brought about these developments. In addition, as markets evolve and new financial instruments are introduced, this will bring about new ways to extract market information which may be highly relevant for monetary policy purposes. The Research Network can make a very valuable contribution on these topics, and generally with respect to the increasing importance of finance research - both at the macro and at the micro level - for central banks. We should also learn more about international financial linkages as well as the role of global trends and other international factors in determining the evolution of financial markets in Europe. The ongoing financial integration process within the euro area should have beneficial effects for monetary policy, for example by facilitating policy signaling and transmission through enhanced market liquidity. Financial integration and international linkages are the core areas of the Research Network. All these issues which I have mentioned are key for policymakers since we need to correctly interpret the information coming from markets, and also understand how monetary policy is propagated to the real economy through financial markets.
I am convinced that the Research Network will contribute significantly to our understanding of these and other issues. I personally will follow the progress of your work with great interest. I would like to end by wishing you a very productive and fruitful workshop, and all the best in your future research work on these important topics.
--------------------------------------------------------------------------------
[1] Michael Woodford, "Monetary Policy in the Information Economy", in Economic Policy for the Information Economy, Kansas City Fed, 2001.
[2] Alan Blinder, "Central Banking in Theory and Practice", MIT Press, 1998, p. 61.
[3] Gaspar, Perez-Quiros & Sicilia (2001), “ The ECB Monetary Policy Strategy and the Money Market", International Journal of Finance and Economics 6(4).
[4] Hartmann, Manna and Manzanares (2001), “ The microstructure of the euro money market", Journal of International Money and Finance 20
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Source
http://www.ecb.int/press/key/date/2002/html/sp020429_1.en.html
Professor Otmar Issing, Launching Workshop of the ECB-CFS Research Network on "Capital Markets and Financial Integration in Europe", Frankfurt am Main, 29 April 2002
Let me first say that it is a great pleasure to open the launching workshop for the Research Network "Capital Markets and Financial Integration in Europe ". Understanding global financial linkages is important, not least from the perspective of a central banker. Further integration of European financial markets is one of the expected benefits from monetary unification. By focusing on these issues, the Network will stimulate research on topics we as policymakers can benefit from.
In my remarks today, I would like to focus on the interaction between the central bank and financial markets. Specifically, I will first address the interdependence between monetary policy making and financial market expectations. Linked to this, I will then discuss some of our experiences of the first years of policy making at the ECB. I will conclude by briefly mentioning the recent changes that we have witnessed in the euro area financial landscape, and touch upon some areas where I believe more research is needed and where your contribution will be particularly valuable.
Let me start by elaborating on the issue of how central bank behaviour affects financial markets. In this respect, financial markets can be seen as a transmission channel of monetary policy. The central bank controls the short-term interest rate, but what matters for consumers' and firms' decisions are market interest rates beyond the direct control of the monetary authority. In this regard, the role of private banks in the transmission of monetary policy has traditionally been strong in the euro area and still plays a dominant role. Increases in liquidity are redistributed to end users through the banking system, at interest rates reflecting both current and expected future refinancing costs for the banks. Therefore, not only the actual situation of banks' balance sheets, but also market expectations about the future course of monetary policy and future inflation become important, since these expectations to a large extent determine those interest rates.
In this context, the monetary policy strategy is crucial. By a clear commitment to price stability, the ECB provides the markets with a reference against which new information can be consistently evaluated. If new information indicates risks to price stability, and markets understand the strategy, expectations will adjust in anticipation of the appropriate reaction of monetary policy. This fosters a smooth implementation of policy, where much of the actual work is done by themarket's adjustment of the term structure of interest rates.
We have structured the strategy of the ECB around two pillars, which can be seen as a means of organising information concerning risks to price stability. The first pillar assigns a prominent role to money, and in this context monetary aggregates are carefully monitored to reveal such threats. Under the second pillar, other macroeconomic and financial variables that contain information about future price developments are analysed. Financial markets, by their inherent forward-looking nature, provide the central bank with valuable information about expected economic developments. Two key markets to be monitored in this context are bond markets and equity markets. The former gives an assessment of expected interest rates through the term structure of interest rates. Bond derivatives can provide important information of the prevailing uncertainty about future interest rate developments. Such information is especially useful when deciding on communication issues, should market expectations deviate too far from the central banks own evaluation of the current circumstances. Equity markets can convey information about future economic activity. They also have a direct role in the transmission of economic shocks, in that changes in consumer's wealth can impact consumption. Traditionally, this effect has been stronger in the US than in Europe . However, recent trends point to an increase in equity holdings by Europeans which might make this channel more important. Increasing globalisation and cross-border ownership seems to have resulted in faster transmission of shocks, perhaps also more oriented towards sectors rather than countries. For example, the recent IT bubble both gained momentum and collapsed simultaneously across a number of countries. This has major impact on our economies because the traditional mitigating effects of trade and diversification do not apply when similar events take place everywhere.
To conclude, under the second pillar the financial markets (as well as other markets such as those for labour and goods) provide the central bank with relevant information about risks to price stability. This, together with the monetary analysis under the first pillar, allows two complementary pictures of the threats to price stability to emerge. In turn, this facilitates cross-checking, stimulates internal discussion, and ultimately, I believe, leads to appropriate monetary policy decisions.
Traditionally, bank lending was the main source of financing economic activities in most countries of the euro area and banks were therefore the main "actors" in the monetary transmission process. However, market based financing has become more important during the last few years. An interesting questions for research is how the evolution of financial markets, for example the continuing expansion of corporate bond markets, will impact the transmission of monetary policy.
Let me turn to the issue of predictability of monetary policy. In the environment I have just described, deliberate attempts to surprise markets would be counterproductive. Rather, implementation of policy will be smoother the more predictable it is. Woodford e.g. emphasises [1] that developments in financial markets have increased the possibilities of the central bank to influence markets, to the extent that it may do so by signalling without actually moving interest rates:
"The more sophisticated markets become, the more scope there will be for communication about even subtle aspects of the bank's decision and reasoning, and it will be desirable for central banks to take advantage of this opportunity."
Communicating with sophisticated financial markets is indeed important. At the same time it is a tricky issue, since the central bank needs to ensure that it guides rather than follows the markets. An eloquent quote by Alan Blinder illustrates the danger of failing to do so:[2] "...Following the markets may be a nice way of unsettling financial surprises, which is a legitimate end in itself. But I fear that it may produce rather poor monetary policy for several reasons. One is that speculative markets tend to run in herds and to overreact to almost everything. Central bankers need to be more cautious and prudent. Another is that financial markets seem extremely susceptible to fads and speculative bubbles which sometimes stray far from fundamentals. Central bankers must innoculate themselves against whimsy and keep their eyes on the fundamentals."
It is of utmost importance that the financial markets believe the stated goals of policy and understand the monetary policy strategy. In time, markets can evaluate the track-record of the ECB relative to the goal of price stability. Adherence to the strategy should gradually enhance the credibility in that markets can interpret monetary policy decisions through the strategy. In this respect, communication with markets is essential to foster a proper understanding of the strategy, and to send clear signals about the central banks current assessment of economic conditions.
It is therefore interesting to study actual developments in market-based indicators in order to gain some insight into how market participants have perceived the predictability and credibility of the ECB. Concentrating initially on the issue of predictability, Gaspar et al. (2001) examine the behaviour of overnight interest rates between the start of 1999 and early 2001[3]. They find that the markets during that period did not appear to make systematic errors with respect to monetary policy announcements. Moreover, Hartmann et al. (2001) find that overnight rates on average moved by less than 5 basis points immediately following monetary policy announcements by the ECB. [4] Finally, if we take a look at the behaviour of implied short-term forward rates at the one-month horizon during the entire period since the introduction of the euro, we see that the majority of ECB interest rate moves have been in line with the expectations of financial market participants. In this regard, the track record of the ECB is comparable to that of other major - and substantially older - central banks, such as the US Federal Reserve or the Bank of England. In my view, this performance is not bad for a young central bank like the ECB.
Of course, one could not claim that the money market has perfectly anticipated policy moves on every single occasion. Sometimes, rapidly changing economic conditions or extraordinary events, such as the September 11 terrorist attacks, require swift and decisive policy action that cannot be fully anticipated in advance. Furthermore, at times the monetary authority has access to information that market participants do not have. This information asymmetry may on rare occasions lead to policy moves that are unexpected by markets. This being said, I again repeat that there can be no interest in the monetary authority deliberately aiming to surprise the financial markets. Such a strategy would merely increase uncertainty in the markets and damage the credibility of the monetary authority.
Turning to this very aspect, taking due account of caveats such as liquidity and risk premia considerations, the market for French index- linked government bonds provides a useful measure of the credibility of monetary policy. The ten-year break-even inflation rate obtained from this market has consistently been in line with the ECB's quantitative definition of price stability, indicating a persistently high degree of credibility. Moreover, there is little evidence that monetary policy moves have generated any systematically higher volatility in the break even rate. This would seem to indicate that markets have perceived ECB monetary policy actions as transparent, in the sense that they do not appear to have induced investors to revise their beliefs about the objective of the ECB. Interestingly, in the last few months, the French treasury has issued new index-linked bonds linked to a measure of euro area HICP, which I am convinced will provide us with additional useful information in this respect.
Consistent with the notion that the monetary policy actions of the ECB have not resulted in increased market uncertainty, there is some evidence that bond market volatility has even declined since the introduction of the euro. For example, since 1999 the implied volatility on 10-year German Bund futures has - apart from a brief surge following September 11 - declined to historically low levels. All these indications from prices of financial instruments, determined by market forces which continuously judge the actions of the ECB, lead me to conclude that our monetary policy has been credible and largely transparent to investors.
This being said, it is also clear to me that we still have much to learn about what determines financial asset prices. Moreover, the nature of financial markets, constantly changing and evolving, adds to the need of widening and deepening our understanding of these markets. This is particularly true for financial markets in the euro area, which arguably have seen the most remarkable pace of change among all developed financial markets over the last few years. For example, the euro area money market has undergone a substantial transformation, including the creation of completely new segments, such as the EONIA swap market. Similarly, the bond market has evolved considerably, with very rapid growth of the corporate bond market segment over the last few years and a sizeable expansion of the international issuance of euro-denominated bonds.
No doubt, the introduction of the single currency and a common monetary policy framework acted as a powerful catalyst in bringing about many of the changes to the euro area financial landscape that we have witnessed in recent years. However, we still need to better understand the exact mechanisms which brought about these developments. In addition, as markets evolve and new financial instruments are introduced, this will bring about new ways to extract market information which may be highly relevant for monetary policy purposes. The Research Network can make a very valuable contribution on these topics, and generally with respect to the increasing importance of finance research - both at the macro and at the micro level - for central banks. We should also learn more about international financial linkages as well as the role of global trends and other international factors in determining the evolution of financial markets in Europe. The ongoing financial integration process within the euro area should have beneficial effects for monetary policy, for example by facilitating policy signaling and transmission through enhanced market liquidity. Financial integration and international linkages are the core areas of the Research Network. All these issues which I have mentioned are key for policymakers since we need to correctly interpret the information coming from markets, and also understand how monetary policy is propagated to the real economy through financial markets.
I am convinced that the Research Network will contribute significantly to our understanding of these and other issues. I personally will follow the progress of your work with great interest. I would like to end by wishing you a very productive and fruitful workshop, and all the best in your future research work on these important topics.
--------------------------------------------------------------------------------
[1] Michael Woodford, "Monetary Policy in the Information Economy", in Economic Policy for the Information Economy, Kansas City Fed, 2001.
[2] Alan Blinder, "Central Banking in Theory and Practice", MIT Press, 1998, p. 61.
[3] Gaspar, Perez-Quiros & Sicilia (2001), “ The ECB Monetary Policy Strategy and the Money Market", International Journal of Finance and Economics 6(4).
[4] Hartmann, Manna and Manzanares (2001), “ The microstructure of the euro money market", Journal of International Money and Finance 20
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STUDY SESSION 15 Fixed Income Investments
STUDY SESSION 15 Fixed Income Investments Basic Concepts
This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.
LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).
Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.
Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.
Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.
This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.
LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).
Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.
Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.
Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.
STUDY SESSION 16 ANALYSIS OF FIXED INCOME
STUDY SESSION 16
ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation
This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.
LEARNING OUTCOMES
Reading 67: Introduction to the Valuation of Debt Securities
The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
Reading 68: Yield Measures, Spot Rates, and Forward Rates
The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.
Reading 69: Introduction to the Measurement of Interest Rate Risk
The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation
This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.
LEARNING OUTCOMES
Reading 67: Introduction to the Valuation of Debt Securities
The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
Reading 68: Yield Measures, Spot Rates, and Forward Rates
The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.
Reading 69: Introduction to the Measurement of Interest Rate Risk
The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
Monday, March 10, 2008
LOS 67 Introduction to the Valuation of Debt Securities
LOS 67 Introduction to the Valuation of Debt Securities
a. explain the steps in the bond valuation process;
Steps involved in bond valuation
The fundamental principle of valuation is that the value is equal to the present value of its expected cash flows. The valuation process involves the following three steps:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.
3. Calculate the present value of the expected cash flows found in step one by using the interest rate or interest rates determined in step two.
a. explain the steps in the bond valuation process;
Steps involved in bond valuation
The fundamental principle of valuation is that the value is equal to the present value of its expected cash flows. The valuation process involves the following three steps:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.
3. Calculate the present value of the expected cash flows found in step one by using the interest rate or interest rates determined in step two.
Estimating Expected Cash Flows - Difficulties
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
Bonds With Difficult Expected Cash Flow Estimation
The bonds for which it is difficult to estimate expected cash flows fall into three categories:
1.Bonds for which the issuer or investor has an option or right to change the contract due date for the payment of the principal. These include callable bonds, puttable bonds, MBSs and ABSs.
2.Bonds for which coupon payment rate is reset occasionally based on a formula with values that change, such as reference rates, prices or exchange rates. A floating-rate bond would be an example of this type of category.
3. Bonds for which investor has the option to convert or exchange the security for common stock.
For more See
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa35.asp
The above page has information useful for the next LOS 67.c also.
and explain the problems encountered when estimating the cash flows for
these bonds;
Bonds With Difficult Expected Cash Flow Estimation
The bonds for which it is difficult to estimate expected cash flows fall into three categories:
1.Bonds for which the issuer or investor has an option or right to change the contract due date for the payment of the principal. These include callable bonds, puttable bonds, MBSs and ABSs.
2.Bonds for which coupon payment rate is reset occasionally based on a formula with values that change, such as reference rates, prices or exchange rates. A floating-rate bond would be an example of this type of category.
3. Bonds for which investor has the option to convert or exchange the security for common stock.
For more See
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa35.asp
The above page has information useful for the next LOS 67.c also.
Computing Value of Bond for a Change in Dicount Rate
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
see
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp
change in the discount rate;
see
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp
Price of a Bond near Maturity Date
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
See
www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp
date, and compute the change in value that is attributable to the passage
of time;
See
www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp
Arbitrage-free Valuation Approach Bonds
LOS
67
.f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
The value of the bond based on the spot rates is the arbitrage-free value.
How Does a Dealer Generate Arbitrage Profits?
A dealer has the ability to strip a security or to take apart the cash flows that make up the bond and create new securites out of them. These Treasury strips can be sold to investors. So if the market price of a Treasury security is less than the value using the arbitrage-free valuation, a dealer will buy the security, strip the bond (break the bond into strips) and then sell the Treasury strips at a higher amount than the purchase price for the whole bond.
See for more
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa37.asp
67
.f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
The value of the bond based on the spot rates is the arbitrage-free value.
How Does a Dealer Generate Arbitrage Profits?
A dealer has the ability to strip a security or to take apart the cash flows that make up the bond and create new securites out of them. These Treasury strips can be sold to investors. So if the market price of a Treasury security is less than the value using the arbitrage-free valuation, a dealer will buy the security, strip the bond (break the bond into strips) and then sell the Treasury strips at a higher amount than the purchase price for the whole bond.
See for more
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa37.asp
LOS 68 Yield Measures, Spot Rates, and Forward Rates
a. explain the sources of return from investing in a bond;
Interest
Capital appreciation
Reinvestment income
-------------
return of Principal
Interest
Capital appreciation
Reinvestment income
-------------
return of Principal
Traditional Yield Measures for Bonds
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
Current yield
To obtain the current yield, the annual coupon interest is divided by the market price.
Yield to maturity
The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price of the investment.
Yield to call
For bonds that may be called prior to the stated maturity date another yield measure is commonly quoted: it is the yield to call.
To compute the yield to call, the cash flows that occur if the issue is called on its first call date are used.
http://www.paranzasoft.com/help/pages/glBondYieldMeasures.html
explain their limitations and assumptions;
Current yield
To obtain the current yield, the annual coupon interest is divided by the market price.
Yield to maturity
The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price of the investment.
Yield to call
For bonds that may be called prior to the stated maturity date another yield measure is commonly quoted: it is the yield to call.
To compute the yield to call, the cash flows that occur if the issue is called on its first call date are used.
http://www.paranzasoft.com/help/pages/glBondYieldMeasures.html
Reinvestment Income and Reinvestment Risk
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
Read about it from
The Handbook of Fixed Income Securities By Frank J. Fabozzi
http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA22&lpg=PA22&dq=reinvestment+income+and+reinvestment+risk&source=web&ots=wJORArm5cR&sig=cHzpjvT_6hs_vYEg0Vr397jLIdk&hl=en
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
Read about it from
The Handbook of Fixed Income Securities By Frank J. Fabozzi
http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA22&lpg=PA22&dq=reinvestment+income+and+reinvestment+risk&source=web&ots=wJORArm5cR&sig=cHzpjvT_6hs_vYEg0Vr397jLIdk&hl=en
Option Adjusted Spread
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
If a bond has embedded options, its Option-adjusted spread (OAS) is the spread at which it presumably would be trading over a benchmark if it had no embedded optionality. More precisely, it is the instrument's current spread over the benchmark minus that component of the spread that is attributable to the cost of the embedded options:
OAS = spread - spread due to option
For more see
http://www.riskglossary.com/link/option_adjusted_spread.htm
option-adjusted spread;
If a bond has embedded options, its Option-adjusted spread (OAS) is the spread at which it presumably would be trading over a benchmark if it had no embedded optionality. More precisely, it is the instrument's current spread over the benchmark minus that component of the spread that is attributable to the cost of the embedded options:
OAS = spread - spread due to option
For more see
http://www.riskglossary.com/link/option_adjusted_spread.htm
OAS - Option Cost Relation
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
with an embedded option;
LOS 69 Interest Rate Risk Measurement
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
The primary focus of interest rate risk is measuring the impact after an adverse rate change. Two approaches are used to measuring interest rate risk: the full valuation approach and the duration/convexity approach.
The full valuation approach also known as scenario analysis. It examines the value of bonds under a variety of interest rate scenario changes. For example, a portfolio manager might examine the change in a bond with assumed interest rate increases of 50, 100,150 and 200 basis point increases and decreases. This approach is useful when there is a good valuation model and can be used for parallel and nonparallel shifts in the yield curve.
Highly leveraged investors (such as hedge fund investors) often use extreme scenario tests, known as stress testing, to examine the impact of wide interest rate changes. This is fine so long as the manager has a good valuation model to estimate what the price of the bonds will be in each interest rate scenario.
The advantage of the duration/convexity measure is that it is a simpler measure that will show how a portfolio or single bond will change if there is change in a parallel fashion.
Material to be added
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
The primary focus of interest rate risk is measuring the impact after an adverse rate change. Two approaches are used to measuring interest rate risk: the full valuation approach and the duration/convexity approach.
The full valuation approach also known as scenario analysis. It examines the value of bonds under a variety of interest rate scenario changes. For example, a portfolio manager might examine the change in a bond with assumed interest rate increases of 50, 100,150 and 200 basis point increases and decreases. This approach is useful when there is a good valuation model and can be used for parallel and nonparallel shifts in the yield curve.
Highly leveraged investors (such as hedge fund investors) often use extreme scenario tests, known as stress testing, to examine the impact of wide interest rate changes. This is fine so long as the manager has a good valuation model to estimate what the price of the bonds will be in each interest rate scenario.
The advantage of the duration/convexity measure is that it is a simpler measure that will show how a portfolio or single bond will change if there is change in a parallel fashion.
Material to be added
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
Convexity is a measure of the curvedness of the price-yield relationship. This curvedness is different for each bond.
The lower the coupon, the greater the convexity.
The longer the maturity, the greater the convexity.
The lower the yield to maturity, the greater the convexity.
In summary, the change in price of a bond comes from two sources: its modified duration and its convexity.
The computation of the price change for a bond that is due to the convexity:
Convexity Effect = 1/2 * Price * Convexity * Δyield²
Callable bonds will exhibit negative convexity at certain price-yield combinations. Negative convexity means that as market yields decrease, duration decreases as well.
See
http://www.investopedia.com/university/advancedbond/advancedbond6.asp
and yield;
Convexity is a measure of the curvedness of the price-yield relationship. This curvedness is different for each bond.
The lower the coupon, the greater the convexity.
The longer the maturity, the greater the convexity.
The lower the yield to maturity, the greater the convexity.
In summary, the change in price of a bond comes from two sources: its modified duration and its convexity.
The computation of the price change for a bond that is due to the convexity:
Convexity Effect = 1/2 * Price * Convexity * Δyield²
Callable bonds will exhibit negative convexity at certain price-yield combinations. Negative convexity means that as market yields decrease, duration decreases as well.
See
http://www.investopedia.com/university/advancedbond/advancedbond6.asp
Duration Measures
LOS
69.e. distinguish among the alternative definitions of duration, and explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options;
DURATION MEASURES
Macaulay Duration: The weighted average time to full recovery of principal and interest payments.
= [ΣCt*t/(1+i)t]/[ΣCt/(1+i)t]
Characteristics of Macaulay Duration:
1. The duration of a bond with a coupon is always less than the term to maturity.
2. The larger the coupon, the smaller the duration.
3. There is normally a positive relationship between term to maturity and duration. As term to maturity increases, so does duration, but at a decreasing rate.
4. There is an inverse relationship between the yield to maturity and duration.
5. Sinking funds and call features can reduce the duration significantly.
Modified duration: an adjusted measure of duration called modified duration can be used to approximate the interest rate sensitivity of a noncallable bond. Modified duration equals Macaulay duration divided by 1 plus the current yield to maturity divided by the no. of payments in a year.
Modified Duration = Macaulay duration[1+(ytm/number of payments per year)]
The percentage change in the price of a bond for a given change in interest rates can be approximated by:
100*ΔP/P = -Dmod*Δi
ΔP = change in price
Δi = change in interest rate
Dmod = Modified duration
For More
http://www.duke.edu/~charvey/Classes/ba350/bondval/duration.htm
69.e. distinguish among the alternative definitions of duration, and explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options;
DURATION MEASURES
Macaulay Duration: The weighted average time to full recovery of principal and interest payments.
= [ΣCt*t/(1+i)t]/[ΣCt/(1+i)t]
Characteristics of Macaulay Duration:
1. The duration of a bond with a coupon is always less than the term to maturity.
2. The larger the coupon, the smaller the duration.
3. There is normally a positive relationship between term to maturity and duration. As term to maturity increases, so does duration, but at a decreasing rate.
4. There is an inverse relationship between the yield to maturity and duration.
5. Sinking funds and call features can reduce the duration significantly.
Modified duration: an adjusted measure of duration called modified duration can be used to approximate the interest rate sensitivity of a noncallable bond. Modified duration equals Macaulay duration divided by 1 plus the current yield to maturity divided by the no. of payments in a year.
Modified Duration = Macaulay duration[1+(ytm/number of payments per year)]
The percentage change in the price of a bond for a given change in interest rates can be approximated by:
100*ΔP/P = -Dmod*Δi
ΔP = change in price
Δi = change in interest rate
Dmod = Modified duration
For More
http://www.duke.edu/~charvey/Classes/ba350/bondval/duration.htm
Duration of a bond portfolio
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
duration writeup
http://www.treasurer.ca.gov/cdiac/publications/duration.pdf
Duration, Convexity, and Other Bond Risk Measures By Frank J. Fabozzi
http://books.google.co.in/books?id=7i6ob9SB5jgC&pg=PA6&lpg=PA6&dq=%22duration+of+a+portfolio%22&source=web&ots=ZmSpP6g2Ks&sig=Jgf-3gdgb2O47YENTrQvTtwJ-OI&hl=en
Osborne, Mike J., "A Simple, Accurate Formula for the Duration of a Portfolio of Bonds Under a Non-Parallel Shift of a Non-Flat Yield Curve" (September 5, 2004). Available at SSRN:
http://ssrn.com/abstract=587242
the portfolio, and explain the limitations of portfolio duration;
duration writeup
http://www.treasurer.ca.gov/cdiac/publications/duration.pdf
Duration, Convexity, and Other Bond Risk Measures By Frank J. Fabozzi
http://books.google.co.in/books?id=7i6ob9SB5jgC&pg=PA6&lpg=PA6&dq=%22duration+of+a+portfolio%22&source=web&ots=ZmSpP6g2Ks&sig=Jgf-3gdgb2O47YENTrQvTtwJ-OI&hl=en
Osborne, Mike J., "A Simple, Accurate Formula for the Duration of a Portfolio of Bonds Under a Non-Parallel Shift of a Non-Flat Yield Curve" (September 5, 2004). Available at SSRN:
http://ssrn.com/abstract=587242
Convexity of a bond
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
Advanced Bond Concepts: Convexity
http://www.investopedia.com/university/advancedbond/advancedbond6.asp
price change, given the bond’s duration and convexity and a specified change in
interest rates;
Advanced Bond Concepts: Convexity
http://www.investopedia.com/university/advancedbond/advancedbond6.asp
Modified Convexity and Effective Convexity
h. differentiate between modified convexity and effective convexity;
From Google books
The Handbook of Fixed Income Securities By Frank J. Fabozzi
http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA116&lpg=PA116&dq=modified+convexity+and+effective+convexity&source=web&ots=wJORAlm2kL&sig=Bv5apvCK-H50KWpySX0uzIRGnrI&hl=en
From Google books
The Handbook of Fixed Income Securities By Frank J. Fabozzi
http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA116&lpg=PA116&dq=modified+convexity+and+effective+convexity&source=web&ots=wJORAlm2kL&sig=Bv5apvCK-H50KWpySX0uzIRGnrI&hl=en
Price value of a basis point (PVBP) Fixed Income Securities
LOS
69.i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
What is basis point value, (BPV)?
BPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or DV01. It is often used to measure the interest rate risk associated with swap trading books, bond trading portfolios and money market books.
It is not new. It has been used for years. In many financial institutions it has been replaced or is used in conjunction with value at risk.
What does it show?
BPV tells you how much money your positions will gain or lose for a 0.01% parallel movement in the yield curve. It therefore quantifies your interest rate risk for small changes in interest rates.
How does it work?
Let's suppose you own a $10m bond that has a price of 100%, a coupon of 5.00% and matures in 5 years time. Over the next 5 years you will receive 5 coupon payments and a principal repayment at maturity. You can value this bond by:
A. Using the current market price from a dealer quote, or
B. Discounting the individual bond cash flows in order to find the sum of the present values
Let's assume you use the second method. You will use current market interest rates and a robust method for calculating accurate discount factors. (Typically swap rates are used with zero coupon methodology).
For the sake of simplicity we will use just one interest rate to discount the bond cash flows. That rate is 5.00%. Discounting the cash flows using this rate will give you a value for the 5 year bond of $10,000,000. (How to do this using a financial calculator is explained on the second page of this document).
We will now repeat the exercise using an interest rate of 5.01%, (rates have increased by 0.01%). The bond now has a value of $9,995,671.72.
There is a difference of $4,328.28.
It shows that the 0.01% increase in interest rates has caused a fall in the value of the bond. If you held that bond you would have lost $4,328.28 on a mark-to-market basis.
This is the BPV of the bond.
For some more details see
http://www.barbicanconsulting.co.uk/quickguides/bpv
69.i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
What is basis point value, (BPV)?
BPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or DV01. It is often used to measure the interest rate risk associated with swap trading books, bond trading portfolios and money market books.
It is not new. It has been used for years. In many financial institutions it has been replaced or is used in conjunction with value at risk.
What does it show?
BPV tells you how much money your positions will gain or lose for a 0.01% parallel movement in the yield curve. It therefore quantifies your interest rate risk for small changes in interest rates.
How does it work?
Let's suppose you own a $10m bond that has a price of 100%, a coupon of 5.00% and matures in 5 years time. Over the next 5 years you will receive 5 coupon payments and a principal repayment at maturity. You can value this bond by:
A. Using the current market price from a dealer quote, or
B. Discounting the individual bond cash flows in order to find the sum of the present values
Let's assume you use the second method. You will use current market interest rates and a robust method for calculating accurate discount factors. (Typically swap rates are used with zero coupon methodology).
For the sake of simplicity we will use just one interest rate to discount the bond cash flows. That rate is 5.00%. Discounting the cash flows using this rate will give you a value for the 5 year bond of $10,000,000. (How to do this using a financial calculator is explained on the second page of this document).
We will now repeat the exercise using an interest rate of 5.01%, (rates have increased by 0.01%). The bond now has a value of $9,995,671.72.
There is a difference of $4,328.28.
It shows that the 0.01% increase in interest rates has caused a fall in the value of the bond. If you held that bond you would have lost $4,328.28 on a mark-to-market basis.
This is the BPV of the bond.
For some more details see
http://www.barbicanconsulting.co.uk/quickguides/bpv
STUDY SESSION 16 ANALYSIS OF FIXED INCOME
STUDY SESSION 16
ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation
This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.
LEARNING OUTCOMES
Reading 67: Introduction to the Valuation of Debt Securities
The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
Reading 68: Yield Measures, Spot Rates, and Forward Rates
The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.
Reading 69: Introduction to the Measurement of Interest Rate Risk
The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation
This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.
LEARNING OUTCOMES
Reading 67: Introduction to the Valuation of Debt Securities
The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
Reading 68: Yield Measures, Spot Rates, and Forward Rates
The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.
Reading 69: Introduction to the Measurement of Interest Rate Risk
The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
Study Session 17 Derivative Investments - LOS
Study Session 17
Derivative Investments
Derivatives − financial instruments that offer a return based on the return of some underlying asset − have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices and maintaining parity.
This study session builds the conceptual framework for understanding derivative investments (forwards, futures, options, and swaps), derivative markets, and the use of options in risk management.
LOS
Reading 70: Derivative Markets and Instruments
The candidate should be able to:
a. define a derivative and differentiate between exchange-traded and over-thecounter
derivatives;
b. define a forward commitment and a contingent claim, and describe the basic
characteristics of forward contracts, futures contracts, options (calls and puts),
and swaps;
c. discuss the purposes and criticisms of derivative markets;
d. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
Reading 71: Forward Markets and Contracts
The candidate should be able to:
a. differentiate between the positions held by the long and short parties to a
forward contract in terms of delivery/settlement and default risk;
b. describe the procedures for settling a forward contract at expiration, and discuss
how termination alternatives prior to expiration can affect credit risk;
c. differentiate between a dealer and an end user of a forward contract;
d. describe the characteristics of equity forward contracts and forward contracts on
zero-coupon and coupon bonds;
e. describe the characteristics of the Eurodollar time deposit market, define LIBOR
and Euribor;
f. describe the characteristics of forward rate agreements (FRAs);
g. calculate and interpret the payoff of an FRA and explain each of the component
terms;
h. describe the characteristics of currency forward contracts.
Reading 72: Futures Markets and Contracts
The candidate should be able to:
a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
c. describe price limits and the process of marking to market, and compute and
interpret the margin balance, given the previous day’s balance and the new
change in the futures price;
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
e. describe the characteristics of the following types of futures contracts: Eurodollar,
Treasury bond, stock index, and currency.
Reading 73: Option Markets and Contracts
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
b. identify the types of options in terms of the underlying instruments;
c. compare and contrast interest rate options to forward rate agreements (FRAs);
d. define interest rate caps, floors, and collars;
e. compute and interpret option payoffs, and explain how interest rate option
payoffs differ from the payoffs of other types of options;
f. define intrinsic value and time value, and explain their relationship;
g. determine the minimum and maximum values of European options and
American options;
h. calculate and interpret the lowest prices of European and American calls and
puts based on the rules for minimum values and lower bounds;
i. explain how option prices are affected by the exercise price and the time to
expiration;
j. explain put-call parity for European options, and relate put-call parity to arbitrage
and the construction of synthetic options;
k. contrast American options with European options in terms of the lower bounds
on option prices and the possibility of early exercise;
l. explain how cash flows on the underlying asset affect put-call parity and the
lower bounds of option prices;
m. indicate the directional effect of an interest rate change or volatility change on
an option’s price.
Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
Reading 75: Risk Management Applications of Option Strategies
The candidate should be able to:
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying and selling calls and puts, and indicate the market outlook
of investors using these strategies;
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
covered call strategy and a protective put strategy, and explain the risk
management application of each strategy.
Specified Readings
"Derivative Markets and Instruments"
Ch. 1, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Forward Markets and Contracts"
Ch. 2, pp. 25-37, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Futures Markets and Contracts"
Ch. 3, pp. 81-103, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Option Markets and Contracts"
Ch. 4, pp. 159-194, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Swap Markets and Contracts"
Ch. 5, pp. 269-285, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Risk Management Applications of Option Strategies"
Ch. 7, pp. 411-429, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
Derivative Investments
Derivatives − financial instruments that offer a return based on the return of some underlying asset − have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices and maintaining parity.
This study session builds the conceptual framework for understanding derivative investments (forwards, futures, options, and swaps), derivative markets, and the use of options in risk management.
LOS
Reading 70: Derivative Markets and Instruments
The candidate should be able to:
a. define a derivative and differentiate between exchange-traded and over-thecounter
derivatives;
b. define a forward commitment and a contingent claim, and describe the basic
characteristics of forward contracts, futures contracts, options (calls and puts),
and swaps;
c. discuss the purposes and criticisms of derivative markets;
d. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
Reading 71: Forward Markets and Contracts
The candidate should be able to:
a. differentiate between the positions held by the long and short parties to a
forward contract in terms of delivery/settlement and default risk;
b. describe the procedures for settling a forward contract at expiration, and discuss
how termination alternatives prior to expiration can affect credit risk;
c. differentiate between a dealer and an end user of a forward contract;
d. describe the characteristics of equity forward contracts and forward contracts on
zero-coupon and coupon bonds;
e. describe the characteristics of the Eurodollar time deposit market, define LIBOR
and Euribor;
f. describe the characteristics of forward rate agreements (FRAs);
g. calculate and interpret the payoff of an FRA and explain each of the component
terms;
h. describe the characteristics of currency forward contracts.
Reading 72: Futures Markets and Contracts
The candidate should be able to:
a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
c. describe price limits and the process of marking to market, and compute and
interpret the margin balance, given the previous day’s balance and the new
change in the futures price;
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
e. describe the characteristics of the following types of futures contracts: Eurodollar,
Treasury bond, stock index, and currency.
Reading 73: Option Markets and Contracts
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
b. identify the types of options in terms of the underlying instruments;
c. compare and contrast interest rate options to forward rate agreements (FRAs);
d. define interest rate caps, floors, and collars;
e. compute and interpret option payoffs, and explain how interest rate option
payoffs differ from the payoffs of other types of options;
f. define intrinsic value and time value, and explain their relationship;
g. determine the minimum and maximum values of European options and
American options;
h. calculate and interpret the lowest prices of European and American calls and
puts based on the rules for minimum values and lower bounds;
i. explain how option prices are affected by the exercise price and the time to
expiration;
j. explain put-call parity for European options, and relate put-call parity to arbitrage
and the construction of synthetic options;
k. contrast American options with European options in terms of the lower bounds
on option prices and the possibility of early exercise;
l. explain how cash flows on the underlying asset affect put-call parity and the
lower bounds of option prices;
m. indicate the directional effect of an interest rate change or volatility change on
an option’s price.
Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
Reading 75: Risk Management Applications of Option Strategies
The candidate should be able to:
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying and selling calls and puts, and indicate the market outlook
of investors using these strategies;
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
covered call strategy and a protective put strategy, and explain the risk
management application of each strategy.
Specified Readings
"Derivative Markets and Instruments"
Ch. 1, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Forward Markets and Contracts"
Ch. 2, pp. 25-37, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Futures Markets and Contracts"
Ch. 3, pp. 81-103, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Option Markets and Contracts"
Ch. 4, pp. 159-194, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Swap Markets and Contracts"
Ch. 5, pp. 269-285, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Risk Management Applications of Option Strategies"
Ch. 7, pp. 411-429, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
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