SOA Exam 6
Section A
Answers
by Cynic
- What’s the difference between floating-rate, extendible-reset, and variable-rate securities? (HBFIS – Pages 7-8)
- Floating-rate securities: rates are reset based on a some index plus a spread; reset more than once a year; reset dates are predetermined
- Extendible-reset securities: rates reset as suggested by at least 2 investment banking firm; different from floaters in that floaters’ reset rates are predetermined
- Variable-rate securities: coupon rates reset not more than once a year
- What are the advantages/disadvantages of a bond call provision to the issuer? to the investor? (HBFIS – Pages 10-12)
- Advantages to issuer
- Be able to refinance when rates go down
- May use high levels of cash to retire bonds
- Can restructure balance sheet if gets influx of capital
- Be able to get out of restrictive asset provision in indenture
- Disadvantages to issuer
- Must issue at a higher yield than noncallable
- Call price is higher than face value
- Advantages to investor
- Higher yield than noncallable
- Call price above par
- Bond call protection period
- Disadvantages to investor
- Less marketable
- Less liquid
- Reinvestment risk
- Limited price appreciation (price can’t rise above a certain level)
- Uncertainty of cash flow
- What’s the difference between a noncallable and a nonrefundable bond? (HBFIS – Pages 10-11)
- Noncallable (NC) can’t be called for any reason during the deferment period; whereas nonrefundable (NF) can be called only if using internally generated fund
- What are zero-coupon treasury securities? (HBFIS – Pages 186-187)
- The Treasury doesn’t issue zero-coupon bonds; zero-coupon treasury securities are created by coupon-stripping
- What are the factors that affect a floater’s price? (HBFIS – Page 331)
- 3 factors: (1) time remaining to the next coupon reset date; (2) changes in market required margin; (3) whether or not the cap or floor is reached
- What’s the difference between ARM (Adjustable-Rate Mortgage) and “Two-Step” Mortgage? (HBFIS – Pages 556-559)
- ARM: reset periodically based on a reference rate plus a spread
- “Two-Step” Mortgage: like ARM with only 1 reset
- What’s the difference between Graduate Payment Mortgage, Growing Equity Mortgage, and Tiered-Payment Mortgage? (HBFIS – Pages 559-560)
- Graduate Payment Mortgage (GPM): fixed rate and maturity, negative amortization in early years
- Growing Equity Mortgage: similar to GPM, but no negative amortization
- Tiered-Payment Mortgage (TPM): similar to GPM, but the beginning shortfall in interest payment is made up for by a buydown account
- Describe the PSA (Public Securities Association) prepayment model. (HBFIS – Page 583)
- Industry standard; use a % of PSA table; assumes .2% per year for first month, increasing linearly to 6% per year at 30th month, constant thereafter; combination of CPR & FHA
- What is the OAS (Option-Adjusted Spread) model? (HBFIS – Pages 599-600)
- This model subtracts a spread from the expected yield spread on the security in order to account for prepayment option; OAS is a spread added to the entire yield curve, whereas yield spread is a spread added to a single point on the yield curve
- Describe each of the following CMO types: (HBFIS – Pages 624-636)
- Sequential-pay: reallocate principal payments sequentially to different classes (or tranches)
- PAC (Plan Amortization Class): PAC schedule is determined by PAC bands; cash flow uncertainty is redirected to companions
- TAC (Target Amortization Class): like PACs, but don’t provide downward protection against WAL (Weighted Average Life) extension
- Companion: support class; influenced by the class it supports
- Z-bond: a CMO class with a period of principal and interest lockout; get credit for the forgone interest payments through the increase in principal known as accretion; have no reinvestment risk and high yield
- AD (Accretion-Directed): derive all cash flows from the interest accretions of a Z class
- Floater and inverse: created from any coupon-bearing class above; inverses usually have higher yields than floaters
- IO and PO (Interest Only and Principal Only strips): IOs are bearish with negative duration (price increases as interest rate increases); POs are bullish with long positive duration
- Summary: a-d are redirect-principal-only CMOs; e-h are redirect-interest-and-principal CMOs
- Describe the 3 approaches in evaluating CMOs. (HBFIS – Pages 643-646)
- Cash flow yield approach: show CF yields under a series of prepayment rate assumptions
- Total return scenario analysis: Total Return = (Change in MV + Value of CFs + Reinvestments)/(Initial Market Value)
- OAS analysis: allows direct comparisons among MBSs and other fixed-income securities
- What are the characteristics of a convertible bond? (HBFIS – Pages 1104-1106)
- Subordinate debenture; similar to a straight bond with an attached warrant; low yield
- What are the advantages/disadvantages of a convertible to the issuer? to the investor? (HBFIS – Pages 1106-1110)
- Advantages to the issuer
- Low interest cost (low yield)
- Less restrictive covenants
- Disadvantages to the issuer
- Capital structure uncertainty
- Face the worst of 2 worlds (if business goes sour, bonds—instead of equity—increase the chance of bankruptcy; if business booms, convertible bonds will be converted and existing shareholders’ share of growth is diluted)
- Advantages to the investor
- More senior security relative to common stock
- Downside protection (income stability)
- Upside potential since tied to common stock price
- Higher current yield than common stock
- Can get equity exposure without investing in a pure equity
- Disadvantages to the investor
- Lower yield than nonconvertible bond
- Yield sacrificed only worth it if stock price rises
- Embedded stock call option overpriced if the stock is stable
- Yield spread may widen as the stock price falls (makes the convertible bond price fall
even faster)
- What are the important GIC (Guaranteed Insurance Contract) characteristics in portfolio construction? (SN 6-23-00)
- Preservation of principal
- Fixed return
- Stated maturity dates
- Negotiated rates
- What are embedded options in GIC and in mortgage?
- Embedded option in GIC: withdrawal option is a put option given to pension fund)
- Embedded option in mortgage: prepayment option is a call option given to the borrower
- What are the advantages/disadvantages of a sinking fund provision to the investor? (HBFIS – Pages 12-13)
- Advantages to investor
- Gradual payment, so final payment won’t be too large
- Liquidity enhancement
- Stable prices
- If rate rises, some bonds are still retired at par
- Disadvantages to investor
- Wastes of time and effort to reinvest
- Forced to relinquish the bond even if receiving high coupons
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Jan 26, 2004