Final Exam Solution
BUFN 762
Fixed Income Securities
Final Exam Solution
1. Briefly explain why many corporations prefer to issue callable long-term corporate bonds rather than noncallable long-term bonds.
There are three main reasons why a corporation may be interested in calling a bond. * Interest rated have fallen, so they can refinance at a lower rate. * Credit quality has improved, so they can refinance at a lower rate. * Assets have been sold, so money is available to pay off debt.
2. Briefly explain the idea behind an Immunized Bond Portfolio.
With an Immunized Portfolio, the duration and convexity of the assets is set to match the duration and convexity of the liabilities. The PV of the assets is set greater than the PV of the liabilities. For small changes in yield, the asset value should increase or decrease proportionally to the changes in the value of the liabilities. This method insures that the return on the assets and the return on the liabilities remain the same. Another way of looking at it is that immunization sets the price risk exactly equal to the reinvestment risk.
3. Explain why an Interest Only Strip (IO MBS) usually gains value when interest rates increase.
IO Strips receive the interest portion of a MBS. If interest rates decrease, then prepayments should speed up. If this happens, then smaller payments are received in the future. While these smaller payments are discounted at a lower rate, the net effect is usually a decrease in value.
4. Briefly explain what happens to the price of a straight bond (no options) when the yield increases – and why.
Price goes down when yields go up. I needed you to tell me why. I accepted any of the three reasons from the Bond Analytics lecture notes.
5. Briefly describe how the Federal Reserve moves rates in the Federal Funds Market.
The Federal Reserve cannot trade in the Federal Funds Market. However, banks have other alternatives for raising cash to
Fixed Income Securities
Final Exam Solution
1. Briefly explain why many corporations prefer to issue callable long-term corporate bonds rather than noncallable long-term bonds.
There are three main reasons why a corporation may be interested in calling a bond. * Interest rated have fallen, so they can refinance at a lower rate. * Credit quality has improved, so they can refinance at a lower rate. * Assets have been sold, so money is available to pay off debt.
2. Briefly explain the idea behind an Immunized Bond Portfolio.
With an Immunized Portfolio, the duration and convexity of the assets is set to match the duration and convexity of the liabilities. The PV of the assets is set greater than the PV of the liabilities. For small changes in yield, the asset value should increase or decrease proportionally to the changes in the value of the liabilities. This method insures that the return on the assets and the return on the liabilities remain the same. Another way of looking at it is that immunization sets the price risk exactly equal to the reinvestment risk.
3. Explain why an Interest Only Strip (IO MBS) usually gains value when interest rates increase.
IO Strips receive the interest portion of a MBS. If interest rates decrease, then prepayments should speed up. If this happens, then smaller payments are received in the future. While these smaller payments are discounted at a lower rate, the net effect is usually a decrease in value.
4. Briefly explain what happens to the price of a straight bond (no options) when the yield increases – and why.
Price goes down when yields go up. I needed you to tell me why. I accepted any of the three reasons from the Bond Analytics lecture notes.
5. Briefly describe how the Federal Reserve moves rates in the Federal Funds Market.
The Federal Reserve cannot trade in the Federal Funds Market. However, banks have other alternatives for raising cash to