CIFA Advanced Level

Fixed Income Investment Analysis flashcards

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What are the five basic features of a bond?

Issuer: the government, agency, supranational or company borrowing the funds. Maturity: the date the principal must be repaid. Par (face) value: the amount repaid at maturity, against which coupons are usually calculated. Coupon rate and frequency: the stated annual interest and how often it is paid. Currency denomination: the currency the cash flows are paid in.

What is the difference between a firm-commitment and a best-efforts bond underwriting?

Firm commitment: the underwriter buys the whole issue and resells it, so it bears the placement risk. Best efforts: the underwriter only tries to sell the issue on the issuer's behalf, so the placement risk stays with the issuer.

What is the difference between a bond's flat (clean) price and its full (dirty) price?

Flat price: the quoted price, excluding interest accrued since the last coupon. Full price = flat price + accrued interest: what the buyer actually pays at settlement. Accrued interest = coupon for the period x (days since last coupon / days in the coupon period).

How is modified duration calculated, and how is it used to estimate a price change?

Modified duration = Macaulay duration / (1 + periodic yield). Approximate percentage price change = -modified duration x change in yield. Example: Macaulay duration 6.5, yield 12%: modified duration = 6.5 / 1.12 = 5.80, so a 0.50% rise in yield gives about -2.90%.

Describe the normal, flat and inverted yield curves.

Normal: slopes upward, longer maturities yielding more; the most common shape. Flat: little difference between short and long yields, often a transition between normal and inverted. Inverted: short maturities yield more than long ones, watched as a possible signal of an expected economic slowdown.

How is the 1-year forward rate one year from today derived from the 1-year and 2-year spot rates?

No arbitrage: (1 + s2)^2 = (1 + s1) x (1 + f1,1). So 1 + f1,1 = (1 + s2)^2 / (1 + s1). Example: s1 = 6.00%, s2 = 7.03%: 1.1455 / 1.06 = 1.0807, so f1,1 = 8.07%.

What does arbitrage-free valuation of a bond mean?

Each cash flow is discounted at the spot rate for its own maturity, not at a single yield to maturity. The bond then cannot be assembled more cheaply or dearly from its separate cash flows bought or sold as zero-coupon instruments, so no riskless arbitrage is left open. A single YTM gives the same value only if the yield curve is flat.

How are a callable bond and a putable bond valued from the straight bond and the embedded option?

Callable bond = straight bond value - value of the issuer's call option (the option favours the issuer). Putable bond = straight bond value + value of the bondholder's put option (the option favours the holder).

How does convexity refine a duration-based estimate of a bond's price change?

Convexity adjustment = 0.5 x convexity x (change in yield)^2. Full estimate = -modified duration x change in yield + convexity adjustment. For an option-free bond the adjustment is always positive: it softens the fall when yields rise and adds to the gain when they fall.

What is a repurchase agreement (repo)?

A short-term collateralised loan structured as the sale of a security with a simultaneous agreement to buy it back later at a slightly higher price. The price difference is the implicit interest, the repo rate. It is a key money market funding tool for banks and other holders of fixed income inventory.

How do fixed-rate, floating-rate, zero-coupon, amortising and inflation-linked bonds differ?