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Category: 101 Concepts for Level I

Concept 80: Mechanisms Available for Issuing Bonds in Primary Markets

Primary markets are markets in which bonds are sold for the first time by an issuer to raise capital. Bonds may be issued in the primary market through a public offering or a private placement. Public offering: Any member of the public may buy the bonds. Four types are: Underwritten offerings: The investment bank buys the entire issue and takes the risk of reselling it to investors or dealers. Best effort offerings: The investment bank serves only as a broker and sells the bond issue only if it is able to do so. (Underwritten and best effort offerings are frequently… Read More

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Concept 81: Repurchase Agreements (Repos)

A repurchase agreement is similar to a collateralized loan. This involves the sale of a security (collateral) with a simultaneous agreement by the seller (borrower) to buy the same security back from the purchaser (lender) at an agreed-on price in the future. The repo rate is the implicit interest rate of a repurchase agreement. The repo margin (haircut) is the difference between the amount borrowed and the value of the collateral. Repurchase agreements are a common source of funding for bond dealers. Instead of borrowing funds if a bond dealer is lending funds, then this agreement is known as a… Read More

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Concept 82: Relationships among a Bond’s Price, Coupon Rate, Maturity, and Market Discount Rate (Yield-to-Maturity)

The yield-to-maturity is the implied market discount rate given the price of the bond. Relationship with bond’s price A bond’s price moves inversely with its YTM. An increase in YTM decreases the price and a decrease in YTM increases the price of a bond. The relationship between a bond’s price and its YTM is convex. Percentage price change is more when discount rate goes down than when it goes up by the same amount. Relationship with coupon rate A bond is priced at a premium above par value when the coupon rate is greater than the market discount rate. A… Read More

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Concept 83: Credit Tranching and Time Tranching

ABS are often created with different types of tranches. The aim is to redistribute prepayment risk and credit risk efficiently among the different tranches. Credit tranching The focus is on redistribution of credit risk – Losses resulting from default of the borrowers whose loans are in the collateral. Any credit losses are first absorbed by the tranche with the lowest priority and after that by any other subordinated tranches, in order. Time tranching The focus is on redistribution of prepayment risk – uncertainty that the actual cash flows will be different from the scheduled cash flows as set forth in… Read More

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Concept 84: Sources of Return From Investing in a Fixed-Rate Bond

For a fixed rate bond purchased at par, there are three sources of return: Receipt of the promised coupon and principal payments. Reinvestment of coupon payments. Potential capital gains (or losses) on the sale of the bond prior to maturity. If a bond is purchased at a discount or premium, the rate of return also includes the effect of the price being “pulled to par” as we approach maturity. Total return of a bond = reinvested coupon interest payments + sale/redemption of principal at maturity. Changes in interest rate affect the realized rate of return for any bond investor in… Read More

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Concept 85: Macaulay, Modified, and Effective Ddurations

Bond duration measures the sensitivity of the bond’s price to changes in interest rates. The three common measures of duration are: Macaulay duration: The weighted average of the time to receipt of coupon interest and principal payments. Modified duration: A linear estimate of the percentage price change in a bond for a 100 basis points change in its yield-to-maturity.           A 12% annual-pay bond has 10 years to maturity. The bond is currently trading at par. Assuming a 10 basis-points change in yield-to-maturity, calculate the bond’s approximate modified duration. Solution: The bond is priced at par… Read More

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Concept 86: Four Cs (Capacity, Collateral, Covenants, and Character) of Traditional Credit Analysis

The components of traditional credit analysis are known as the 4 Cs: Capacity: The ability of the borrower to make interest and principal payments on time. Capacity to repay is assessed by examining: Industry structure à industry fundamentals àcompany fundamentals àcompetitive position. Collateral: The quality and value of the assets pledged as collateral against the debt. Covenants: Provisions in a bond indenture that protect the lenders by requiring the borrower to perform some actions (affirmative covenants) or avoid some actions (negative covenants). Covenant analysis is especially important for high-yield bonds. Character: Refers to the quality of the management, strategy, quality… Read More

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Concept 87: Factors that Influence the Level and Volatility of Yield Spreads

Credit cycle: Credit spreads narrow when the credit cycle improves; and they widen when the credit cycle is weakening. Broader economic conditions: Credit spreads widen in a weak economy and tend to narrow in a strong economy. Market performance: Credit spreads widen in weak financial markets and tend to narrow under stable market conditions. Broker-dealers’ willingness to provide sufficient capital for market listing: Unlike stocks that primarily trade on exchanges, bonds trade over-the-counter. Brokers and dealers are market makers in the debt market. Credit spreads tend to narrow if the availability of capital from broker/dealers is high. Supply and demand:… Read More

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Concept 88: Forward Contracts, Futures Contracts, Options (Calls and Puts), Swaps, and Credit Derivatives

Forward contract is an obligation for one party to buy and another party to sell, an underlying asset at a specific price at a specific time in the future. It is an over-the-counter contract. Futures contract is similar to a forward contract but is a standardized contract and is traded on a futures exchange. Since it is an exchange traded derivative instrument, there is a daily settling of gains and losses. An option is a derivative contract in which the option buyer pays a sum of money to the option seller, and receives the right to either buy or sell… Read More

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Concept 89: Purposes of and Controversies Related to Derivative Markets

Purposes: facilitate the transfer of risk allows strategies and payoffs not otherwise possible with spot assets provide information about the spot market offer lower transaction costs reduce the amount of capital required easier to short derivative than it is to short the underlying improve the efficiency of spot markets Controversies: They are sometimes referred to as a form of legalized gambling that can lead to destabilizing speculation.

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