Someone recently bought our

students are currently browsing our notes.

X

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 2 CFA Level 1

Fixed Income

Nonrefundable Bond (Call Protection)
 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 3 CFA Level 1

Fixed Income

 Event Risk
 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
4 CFA Level 1

Fixed Income

Valuation of Zero-coupon Bond
 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 6 CFA Level 1

Fixed Income

 Bonds in unregistered form
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 7

Buy the full version of these notes or essay plans and more in our CFA Level 1 Notes.