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Cfa1 7 Fixed Income Notes

Finance Notes > CFA Level 1 Notes

This is an extract of our Cfa1 7 Fixed Income document, which we sell as part of our CFA Level 1 Notes collection written by the top tier of University Of London (examined By LSE) students.

The following is a more accessble plain text extract of the PDF sample above, taken from our CFA Level 1 Notes. Due to the challenges of extracting text from PDFs, it will have odd formatting:

CFA Level 1

Fixed Income

Debt Securities
Indenture
Set forth the promises of the issuer and rights of the bondholders
Affirmative Covenant
Set forth activities that the borrower promises to do
Negative Covenant
Set forth certain limitations and restrictions on the borrower's activities
Maturity
No. of years remaining prior to final principal payment
Par Value (Principal Value / Face Value / Redemption Value / Maturity Value)
Amount the issuer agrees to repay the bondholder at or by the maturity date
Coupon Rate (Nominal Rate)
Interest Rate the issuer agree to pay each year
Coupon = Coupon Rate  Par Value
Zero-Coupon Bond
Bond not contracted to make periodic coupon payments and sold at a discount to its principal value as interest
Step-Up Note
Securities with an increasing a coupon rate over time
Deferred Coupon Bond
Bond with interest payments deferred for a specified no. of years
Floating-Rate Security (Variable-Rate Security)
Security with coupon payments being reset periodically according to a reference rate
Coupon Rate = Reference Rate + Quoted Margin
Cap
Restriction on the max coupon rate that will be paid at any reset date
Floor
Restriction on the min coupon rate that will be paid at any reset date 1 CFA Level 1

Fixed Income

Inverse Floater (Reverse Floater)
Increase in reference rate will result in a decrease in coupon rate or vice versa for hedging purposes
Inverse Floater Coupon Rate = K - L  (Reference Rate)Reference Rate)
K and L are specified in the prospectus
Accrued Interest
Interest not yet paid to but earned by the bond seller is transferred to the bond buyer when the bond is sold
Full Price (Dirty Price)
Bond price that includes accrued interest
Clean Price
Bond price that exclude accrued interest
Bullet Maturity Bond
A coupon paying debt instrument with no repayment of principal until maturity
Call Provision
Provision in the callable bond that allows the issuer to retire the bond before the maturity date by paying the stated call price (Reference Rate)redemption price) to the bondholder
Disadvantages of Callable Bond to Bondholders
Unknown cash flow pattern
Decrease in appreciation potential of bond price
Types of Call Prices
Single Call Price Regardless of Call Date
Call Price Based on Call Schedule
Call Price Based on Make-Whole Premium
Make-Whole Call
Issue has to make a lump sum payment derived from a formula based on NPV of future coupon payments that will not be paid because of the call
Noncallable Bond (Redemption Protection)
Bond containing a provision that the holder cannot redeem the security prior to maturity
Nonrefundable Bond (Call Protection)
2 CFA Level 1

Fixed Income

Bond containing a provision that the issuer cannot call the security prior to maturity
Prepayment
Any principal payment prior to maturity
Sinking Fund Provision
Requirement that the issuer must retire a specified portion of the issue each year until all of the issue is retired at maturity to reduce credit risk
Convertible Bond
Right for the bondholder to convert the bond for a specified no. of ordinary shares
Put Provision
Right for the bondholder to sell the issue back to the issuer at a specified price on designated dates
Common Embedded Options Granted to Issuers
Right to call the issue
Cap on a floater
Common Embedded Options Granted to Bondholders
Conversion privilege
Right to put the issue
Floor on a floater
Repurchase Agreement
Agreement from the seller to buy back the security at a specified price and date
Bond Risks
Types of Risks Borne by Bondholders
Interest Rate Risk
Call and Prepayment Risk
Yield Curve Risk
Reinvestment Risk
Credit Risk
Liquidity Risk
Exchange-Rate Risk
Volatility Risk
Inflation / Purchasing Power Risk
Event Risk 3 CFA Level 1

Fixed Income

Sovereign Risk
Interest Rate Risk (Interest Rate, Bond Price)
Coupon Rate = Interest Rate  Bond Price = Par Value
Coupon Rate > Interest Rate  Bond Price > Par Value (Reference Rate)Premium)
Coupon Rate < Interest Rate  Bond Price < Par Value (Reference Rate)Discount)
Sensitivity to Interest Rate Risk
Maturity (Reference Rate)Longer Maturity, Sensitivity)
Coupon Rate (Reference Rate)Lower Coupon Rate, Sensitivity)
Yield Level (Reference Rate)Lower YTM, Sensitivity)
Embedded Option (Reference Rate)Sensitivity) vs Option Free (Reference Rate)Sensitivity)
Floating Rate (Reference Rate)Sensitivity) vs Fixed Rate (Reference Rate)Sensitivity)
Sensitivity of Embedded Options to Interest Rate Risk
Callable Options
Limit the upside price movement of a bond
Bond price will not rise above the call price
Putable Options
Limit the downside price movement of a bond
Bond price will not fall below the put price
Callable Bond Price = Option-free Bond Price - Embedded Call Option
Duration
Measure of price sensitivity of a security to changes in yield
Formula 1
Duration = (Reference Rate)Price if yield declines by X basis points - Price if yield rises by X basis points) / [2 
(Reference Rate)Initial Price)  (Reference Rate)X basis points in decimal)]
Formula 2
Duration = - (Reference Rate)Percentage Change in Price / Change in Yield)
Valuation of Bond
Periodic Coupon Payment (Reference Rate)C)
PV = C / (Reference Rate)1 + YTM) + C / (Reference Rate)1 + YTM)2 + … + (Reference Rate)C + P) / (Reference Rate)1 + YTM)T
Valuation of Zero-coupon Bond 4 CFA Level 1

Fixed Income

PV = FV / (Reference Rate)1 + YTM)T
Valuation of Perpetuity
PV = C / YTM
Basis Point 1 Basis Point = 0.01%
Yield Curve Risk
Possibility of changes in the shape of the yield curve (Reference Rate)e.g. nonparallel shift)
Yield Curve
Relationship between yield and maturity
Call Risk
Issuer pays back the principal to the bondholder prior to maturity
Interest Rate, Call Risk
Prepayment Risk
Borrower pays back the amount borrowed to the lender prior to maturity
Interest Rate, Prepayment Risk
Reinvestment Risk
Risk that the proceeds received from the payment of interest and principal that are available for reinvestment must be reinvested at a lower interest rate
Credit Risk
Risk that the creditworthiness of a fixed-income security's issuer will deteriorate
Components of Credit Risk
Default Risk
Credit Spread Risk (Reference Rate)Risk Premium)
Downgrade Risk (Reference Rate)Credit Rating)
Risky Bond Yield = Risk-free Bond Yield + Risk Premium
Risk Premium = Credit Spread
Liquidity Risk
Risk that the investor will have to sell a bond below its indicated value
Bid-ask Spread, Liquidity Risk
5 CFA Level 1

Fixed Income

Exchange Rate / Currency Risk
Risk that the exchange rate of a foreign bond will fluctuate
Inflation / Purchasing Power Risk
Risk that arises from the decline in the value of a security's cash flow due to inflation
Volatility Risk (Embedded Option)
Risk that the bond price will fluctuate due to changes in interest rate volatility
Expected Yield Volatility, Value of Embedded Option
Callable Bond Rice = Option-free Bond - Embedded Call Option
Putable Bond Price = Option-free Bond + Embedded Put Option
Volatility Risk of Callable Bond
Due to an increase in expected yield volatility
Volatility Risk of Putable Bond
Due to a decrease in expected yield volatility
Event Risk
Natural disaster / industrial accidents
Takeover / corporate restructuring (Reference Rate)downgrade risk)
Regulatory change
Sovereign Risk
Risk that is borne by investors acquiring a bond issued by a foreign government
Components of Sovereign Risk
Unwillingness of a foreign government to pay
Inability of a foreign government to pay
Bond Market
Internal Bond Market (National Bond Market)
Domestic Bond Market
Foreign Bond Market
External Bond Market (Eurobond Market)
Bonds underwritten by an international syndicate
Bonds simultaneously offered to investors in several countries
Bonds in unregistered form 6 CFA Level 1

Fixed Income

Sovereign Bonds
Bonds issued by a country's central government
Credit Risk of Sovereign Bonds
Domestic Currency Denominated Debt (Reference Rate)Lower credit risk because Gov has control over its financial system)
Foreign Currency Denominated Debt (Reference Rate)Higher credit risk because Gov has to purchase foreign currency to repay its debt)
Methods of Distributing New Government Securities
Regular Auction Cycle / Multiple-price Method
Debt is auctioned periodically according to a cycle
Winning bidders receive the bonds at the price they bid
Regular Auction Cycle / Single-price Method
Debt is auctioned periodically according to a cycle
Winning bidders receive bonds at the highest price accepted by Gov
Ad hoc Auction Method
Gov auctions new bonds when the market condition becomes favorable to it
Tap Method
Additional bonds identical to previously issued bonds are issued and auctioned
Fixed-Principal Treasury Securities
Treasury Bill
Maturity < 1 Year
Issued at a Discount to Par
No Periodic Coupon Payments (Reference Rate)Zero Coupon)
Treasury Note 1 Year < Maturity < 10 Years
Issued at Approximately Par
Semiannual Coupon Payments Fixed at Issuance
Treasury Bond
Maturity > 10 Years 7

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