Good topic. No idea what to expect on the exam from fixed income. I’ve always struggled with the “simple” foward pricing and rate models… par/spot/forward curves. All the way back to Level 1, ugh. Seeing as how it’s the first part of the first reading I take that as “this is the easiest stuff, what is wrong with you?”. But I always find myself frozen when I get asked a question on it.
The binomial trees are just all about careful inputs, knowing when to call/put/add OAS/caps/floors, etc. Going to make sure and go slow on those. Structural/reduced form will definitely be a part of it but I think all conceptual. As for ABS… just gotta know your instruments and how they work.
Definitely doing a quick run through of the BBs for these readings today as my final topic prep. I can’t possibly do anything more for FRA than pray, so FI is my last ditch effort to grab some points.
SMM = repayment / (beginning month principal / scheduled repayment)
The higher the PSA, the lower the average life, the higher the contraction risk
Interest rates fall? More people will refinance their debt obligations, PSA increases
There is Loan-Level (defeasance, prepayment lockout, prepayment fee, yield maintenance) protection and Structural Level protection (sequential pay and support/pac duo)
Gross interest = WAC * beginning obligation
Net interest = passing-through rate * beginning obligation
PMT - Gross interest = scheduled repayment
Total cash outflow = net interest + scheduled repayment + prepayment
CMOs re-allocate extention and contraction risks (differentiation)
CDOs have managers buying and selling collateral, trying to maximize the subordonate tranche
Didn’t see anyone answer this – the trick is the question only asks “if the shape of the curve changes, what’ll happen?” So you gotta ignore the volatility change. Just like the question before asks “if the vol changes, what happens?”, so for that one you ignore the steepening.
Conversion ratio is the number of common stocks that the bond holders receive from converting the bonds into shares. Ex: 1 bond = 14,000 share => conversion ratio: 14,000
Conversion value = Underlying share price x conversion ratio
Minimum value of a convertible bond = Max [conversion value , value of the underlying option free bond]
Market Conversion Price = Convertible Bond Price/Conversion ratio
For convertible bonds with put option : (1) Hard put: the issuer must redeem the convertible bond for cash (2) Soft put: the issuer may redeem the convertible bond for cash, common stock, subordinted note and/or combination of the three
For convertible bonds with call option: The issuer can call the bond when (1) interes rates are falling (2) its credit ratings are revised upward (3) The underlying share price increases above the conversion price (i.e: forced conversion => strengthen the issuer’s capital structure)
Price behavior of a convertible bond and the underlying common stock
Share price WELL BELOW conversion price: Convertible bond price behavior similar to straight bond price => Bond equivalent
Share price BELOW conservsion price and increases towards it : Hybrid instrument
Share price ABOVE conversion price and decreases towards it: HYbrid instrument
Share price WELL ABOVE conversion price: Convertible bond price behavior similar to stock. In this case changes in interests don’t make significant changes in the price of convertible bond.
I feel terribly overconfident about fixed income right now and I really really don’t like this feeling. Argh! Cfai should’ve given more practice q on this
I don’t see the word “calculate” in any of the LOS for the ABS reading (46). Not sure you need to worry about the formula, but rather just know what it’s measuring.
I like to throw out crude formulas for some reason.
The proper is (as been mentioned) 1-CPR = (1-SMM)^12
Or CPR = 1 - 1/(1+SMM)^12 (less approximate)
Just understand that these are rates of prepayment on principal, then write them out as you understand them. I rarely memorize, this is why sometimes I spit it out wrong from memory without thinking about it.