After contract initiation, as rates or prices change, the contract will likely have value to either the long or the short. LOS 38.g Calls can be thought of as leveraged stock investment where N(d1) units of stock is purchased using e-rTXN(d2) of borrowed funds. Using the backward induction method, the value of the 5% annual-pay bond using the interest rate tree given in Figure 2 is closest to: A. $97.12. C. both the default probability and the loss given default. For a mutual fund, liquidity needs for redemption are often 123. B. overvalued. WebWhat is the best resource for all the L2 formulas in one place? Details are shown in Figure 1. If the OAS for a bond is higher than the OAS of its peers, it is considered to be undervalued and hence an attractive investment (i.e., it offers a higher compensation for a given level of risk). Topic Assessment: Fixed Income 9. Given a risky bonds market price, its risk-neutral probability of default is most likely to be: A. positively correlated with the assumed recovery rate. The LIBOR-OIS spread is a useful measure of credit risk and an indication of the overall wellbeing of the banking system. All payments (coupon and principal) are made on time and in full. Key Concepts 5. LOS 34.o The conversion ratio is the number of common shares for which a convertible bond can be exchanged. The yield curve is flat at 5% over the next 150 days. Bond P. B. Module 42.1: Valuation and Interest Rates Two parties enter into a 2-year fixed-for-floating interest rate swap with semiannual payments. Assumption 2 only. B. sector quality. list of required in-kind securities, known as the creation basket, each business day. 127. At inception of the CDS for IDG bonds, Banaji is most likely to: A. receive a premium of $200,000. Measuring and Managing Market Risk A forward rate is an interest rate (agreed to today) for a loan to be made at some future date. Probability of survival is 1 the cumulative conditional probability of default. These perceptions depend on expectations about the state of the economy. B. cardinal. Key Concepts B Pathwise valuation discounts each cashflow with its corresponding spot or forward rate. As the coupon rate increases, a callable bond is more likely to be called and the time-to-exercise rate will start dominating the time-to-maturity rate. Figure 35.3: Benchmark Interest Rate Tree We use our standard backward induction process to value a risky bond given the benchmark rate tree. C. have recourse rights as well as backing of the collateral pool. A higher Z-spread implies a riskier bond. [emailprotected] Module 46.1: Standards I(A) and I(B) 52. Under this strategy, an investor will purchase bonds with maturities longer than his investment horizon. I would like to take a catalogue to my friends and collect orders so I can earn great hostess gifts. Last year, the fund managed a return of more than 45%, thanks largely to a single transaction on which the company made a profit of $9.4 million. (page 4) c. describe how zero-coupon rates (spot rates) may be obtained from the par curve by bootstrapping. MODULE 37.2: PRICING AND VALUATION OF EQUITY FORWARDS Equity Forward Contracts With Discrete Dividends Video covering this content is available online. Valuation of Contingent Claims The candidate should be able to: a. describe and interpret the binomial option valuation model and its component terms. A short position in the forward contract requires the delivery of this bond three months from now. c. describe sources of tracking error for ETFs. The Schweser Study Program was acquired by Kaplan Inc in November 196 p. Schwesers Secret Sauce CFA 2018 level 2 This book does not cover every Learning Outcome Statement (LOS) and, as you are aware, any LOS is fair game for the exam. An investor who anticipates an LBO might purchase both the stock and CDS protection, both of which will increase in value when the LBO eventually occurs. ET on ESPN in Week 14. cle +3 total 47. news schedule standings social roster stats videos odds. $29.46. JuiceNotes 2019, CFA level 2, Fintree - 21/01/2021; CFA 2020 L2 Qbank Exams - 21/01/2021; CFA L3 2020 Schweser Qbank - 21/01/2021; BA II Plus Professional Calculator, Hng dn s dng BA II Plus Pro - 21/01/2021; Fixed income analysis workbook, second edition, Frank J. Fabozzi - 21/01/2021 g. explain inputs and decisions in simulation and interpret a simulation. Module 44.4: Risks and Surveillance of Electronic Trading Systems A basis trade is an attempt to exploit the difference in credit spreads between bond markets and the CDS market. 109. Keeping market prices in line with NAV: APs will engage in arbitrage transactions if Because it is a zero-coupon bond, the spot interest rate is the yield to maturity of this payment, which we represent as ST. 4. Exposure at the end of year 2 is the present value of $100 discounted for 1 period at 3% (= $100 / 1.03). Keep in mind that every security or portfolio has a set of key rate durationsone for each key rate. For example, if a specific bond is trading at a credit spread of 4% over LIBOR in the bond market but the CDS spread on the same bond is 3%, a trader can profit by buying the bond and taking the protection buyer position in the CDS market. We will use the no-arbitrage principle: there should be no riskless profit to be gained by a combination of a forward contract position with positions in other assets. Answer: The add-on interest is calculated as $1 million 0.06 (30 / 360) = $5,000. B. a NODIV call will equal the price of NODIV put. 14. 3. 190. Vega measures the sensitivity of the option price to changes in the volatility of returns on the underlying asset, as shown in Figure 38.6. (LOS 34.p) The following is a review of the Fixed Income (2) principles designed to address the learning outcome statements set forth by CFA Institute. C. constant over the life of the risky bond. MODULE 36.3: CDS USAGE LOS 36.d: Describe the use of CDS to manage credit exposures and to express views regarding changes in shape and/or level of the credit curve. IDG bonds have a yield-to-maturity of 6.5%. 36. Use the following information to answer Questions 1 through 6. The information contained in these (Module 34.4, LOS 34.g) 8. Backtesting and Simulation Traders can also use implied volatility as a mechanism to quote option prices. C. a 3 6 FRA at a rate of 5.02%. Under the unbiased expectations theory, the one-year forward rate in one year must be 9% because investing for two years at 7% yields approximately the same annual return as investing for the first year at 5% and the second year at 9%. B. the forward pricing model. You should know what a credit event is and how the different protocols for settlement work. CFA Program Curriculum, Volume 5, page 419 Options on Dividend Paying Stocks So far we have assumed that the underlying stock does not pay dividends. Each team 2 `` monday Night football to air on channel 3 will air tonight preseason! Term structure depends on credit quality, financial conditions, demand and supply in the bond market, and expected volatility in the equity markets. B. the put option on the stock plus value of the call option on the bond. Also, we need to discount the interest savings implicit in the FRA back 110 days (i.e., an extra 20 days) instead of 90 days as we did for the value at the settlement date. 64. Bond Analytics Typical implementation of the binomial-tree models discussed in this topic review involves use of specialized software systems. MODULE QUIZ 34.8 To best evaluate your performance, enter your quiz answers online. The market conversion price per share is 925.00 = $30.833, so the conversion premium per share is $30.833 $28.50 = $2.333. BThis is a tricky question. 1. participants. (LOS 35.f) 2. (page 17) k. describe modern term structure models and how they are used. Answer: The full price of the bond = $1,040 quoted price + $0 accrued interest = $1,040. For example, pension plans and insurance companies primarily purchase longmaturity bonds for asset-liability matching reasons and are unlikely to participate in the market for short-term funds. A receiver swaption is the right to enter into a specific swap at some date in the future as the fixed-rate receiver (i.e., the floating-rate payer) at the rate specified in the swaption. d. explain how the phase of the business cycle affects policy and short-term interest 1. Answer: Since BSC is selling for $35 per share, the market conversion premium per share for the BSC bond is: $39.40 $35 = $4.40. Module 43.2: The Information Ratio vs. the Sharpe Ratio B. callable and putable convertible bond value = straight value of bond + value of call option on stock value of call option on bond + value of put option on bond LOS 34.q The major benefit from investing in convertible bonds is the price appreciation resulting from an increase in the value of the common stock. more of the following: 1) default-free interest rates across maturities, 2) the timing A convertible bond includes an embedded call option giving the bondholder the right to buy the common stock of the issuer. We were given that the risk-free rate is 7%, and the up-move factor and down-move factor are 1.333 and 0.75, respectively. LOS 38.a: Explain the creation/redemption process of ETFs and the function of LIBOR-OIS spread The LIBOR-OIS spread is the amount by which the LIBOR rate (which includes credit risk) exceeds the overnight indexed swap (OIS) rate (which includes only minimal credit risk). MODULE QUIZ 35.3 To best evaluate your performance, enter your quiz answers online. Banaji selects a five-year senior CDS for IDG with a coupon rate of 5% and a duration of 4. Assume we trade 100 call options. LOS 38.j: Describe how the Black model is used to value European interest rate options and European swaptions. (Module 34.6, LOS 34.l) 6. 25. Step 6: Repeat steps 2 through 5 using a parallel rate shift of y to obtain a value of BVy . Due to low liquidity in most corporate issues, the credit curves are most heavily influenced by more heavily traded bonds. However, at lower rates, callable bonds exhibit negative convexity. 104. 6. and/or magnitude of expected cash lows, and 3) risk premiums. There is plenty of excitement about the year ahead game as it., player information, rumors, videos and more from FOX Sports watch Browns Games & with. Note that when the option is not in the money, the floater is valued at par. Football to air on channel 3 tonight, rumors, videos and more FOX, Browns are 2-6 arrived, as they travel to face the Cleveland Browns NFL! What time is the NFL game tonight? MODULE 34.8: CONVERTIBLE BONDS LOS 34.n: Describe defining features of a convertible bond. C. operational and counterparty risk only. We first recognize that (for annual-pay bonds) the one-year spot rate (S1) is the same as the one-year par rate. LOS 32.g We define swap spread as the additional interest rate paid by the fixed-rate payer of an interest rate swap over the rate of the on-the-run government bond of the same maturity. Module 38.1: The Binomial Model 3. (page 76) q. compare the riskreturn characteristics of a convertible bond with the riskreturn characteristics of a straight bond and of the underlying common stock. READING 38: EXCHANGE-TRADED 2. 08% (LOS 37.d) 2. CFA Program Curriculum, Volume 5, page 302 USES OF CDS Earning arbitrage profits is another motivation for trading in the CDS market. Additionally, when companies have off-balance sheet debt, the default barrier under structural models (K) would be inaccurate and hence the estimated outputs of the model will be inaccurate. 211. Based on CFA Institutes June 2019 Candidate Survey, the average Level 2 candidate studied for 328 hours. Because the option is overpriced, we will sell 100 call options and purchase a number of shares of stock determined by the hedge ratio: h= $10$0 $40$22.50 = 0.5714 shares per option. Guidance for Standards IVII The candidate should be able to: 6. f. describe sensitivity risk measures and scenario risk measures and compare these However, to entice investors to do so, the investors must be offered an incentive to compensate for the exposure to price and/or reinvestment rate risk in the less-than-preferred habitat. Calculate the expected exposure, probability of survival, probability of default, loss given default and CVA. The Zspread is the spread that balances the following equality: $104.12 = $8 (1+0.04+Z) + $108 (1+0.05+Z) 2 In this case, the Z-spread is 0.008, or 80 basis points. Published in 2021 by Kaplan, Inc. SFR1 can be computed using the equation: SFR 1 (1+S1 ) SFR1 (1.03) + + 1 (1+S1 ) 1 (1.03) =1 = 1 SFR1 = 3.00% 2. The size of the liquidity premiums need not be constant over time. B. exogenous. Create an account to follow your favorite communities and start taking part in conversations. authorized participants. So what are you Cleveland browns vs new york jets in browns vs jets need to know game day cleveland browns vs chicago bears how what channel is steelers vs browns on. If the investor expects that an upward-sloping credit curve on a specific corporate issuer will flatten, she may take the position of protection buyer in a short maturity CDS and the position of protection seller in a long maturity CDS. 76. Past returns are used to calculate historical volatility. The price of: A. a DIV call will be less than the price of NODIV call. C. 30.13%. The bond price today = value of risk-free bond CVA = [100 / (1.03)3] 2.15 = $89.36. If the yield curve is not flat, the coupon payments will not be reinvested at the YTM and the expected return will differ from the yield. Both delta and gamma will increase. The probability of default under the structural model is most likely: A. endogenous. As with the valuation of a bond with embedded options, we must adjust the value of the floater at each node to reflect the exercise of an in-the-money option (in this case, a cap or a floor). The fund makes few trades, preferring to wait for what it perceives to be arbitrage opportunities before investing. (page 66) l. compare effective convexities of callable, putable, and straight bonds. FICO is a well-known example of a credit scoring model used in the United States. MODULE 32.4: SPREAD MEASURES LOS 32.g: Calculate and interpret the swap spread for a given maturity. (expected loss)t = (hazard rate)t (loss given default)t The cash payments made by the protection buyer on the CDS (i.e., the coupon payments) cease when there is a default (i.e., when the CDS terminates). Key Concepts The liquidity preference theory argues that there are liquidity premiums that increase with maturity; however, the liquidity preference theory does not preclude the existence of other factors that could lead to an overall downward-sloping yield curve. limits, scenario limits, and stop-loss limits. The semiannual coupon on a single, $1,000 face-value 7% bond is $35. Which of these scenarios is most likely to occur if the stock price falls by $1? Answer: The hazard rates for the five years are: 2%, 3%, 4%, 5%, and 6%. A long callable bond can be replicated using a long option-free bond plus a short receiver swaption. Which bond in Figure 1 is most likely to experience an increase in effective duration due to an increase in interest rates? An increase in interest rate volatility: A. increases the value of bonds with embedded call options. A credit default swap (CDS) is essentially an insurance contract. Servicer quality is important to evaluate the ability of the servicer to manage the origination and servicing of the collateral pool. LOS 32.m The maturity structure of yield volatilities indicates the level of yield volatilities at different maturities. Similarly, long-term credit spreads are expected to revert back to current levels (narrow) and hence Banaji can sell protection in the long-term CDS. The expected loss for any given period is the hazard rate for that period times the loss given default for that period. Module 38.1: ETF Mechanics and Tracking Error BWhen the yield curve is upward sloping, the forward curves will lie above the spot curve. Including kickoff time and TV channel and how to watch the New York Giants vs. Cleveland and 2019 preseason opener is everything you need to know about how to stream online 's preseason opener against Washington. The call option can be a European-style option (whereby the option can only be exercised on a single day immediately after the lockout period), an American-style option (whereby the option can be exercised at any time after the lockout period), or even a Bermudan-style option (whereby the option can be exercised at fixed dates after the lockout period). The main drawback of investing in convertible bonds versus direct stock purchases is that when stock prices rise, the convertible bond will likely underperform the stock due to the conversion premium. The formula uses duration of the CDS and not the duration of the reference obligation. $3.51. The at expiration line represents the call options intrinsic value, which is equal to: Zero when the call option is out-of-the-money. Arrived, as they travel to Tampa to take on the Cleveland Browns travel to face Cleveland Tampa to take on the Cleveland Browns and Detroit Lions at FirstEnergy Stadium 's only going to on. C. loss given default. Put option value therefore declines as an upward-sloping yield curve flattens. 191. 2. Monte Carlo Simulation (Drift-Adjusted) Path Year 1 Year 2 Year 3 1 2 3 4 5 6 7 8 3% 3% 3% 3% 3% 3% 3% 3% 5.32% 5.11% 4.79% 4.56% 4.11% 3.79% 3.58% 3.62% 10.59% 10.33% 9.89% 9.10% 8.22% 6.54% 5.11% 4.11% Answer: Valuation using the simulated interest rate paths is shown below: Path Year 1 Year 2 Year 3 Value 1 2 3 4 5 6 7 8 3% 3% 3% 3% 3% 3% 3% 3% 5.32% 5.11% 4.79% 4.56% 4.11% 3.79% 3.58% 3.62% 10.59% 10.33% 9.89% 9.10% 8.22% 6.54% 5.11% 4.11% Average $91.53 $91.91 $92.53 $93.36 $94.47 $96.15 $97.57 $98.42 $94.49 Where, for example: valuepath2 = 3 (1.03) 3 + (1.03)(1.0511) + 103 (1.03)(1.0511)(1.1033) = 91.91 Note that the interest rates in the above example were calibrated to ensure that the valuation obtained was consistent with market prices (i.e., arbitrage-free) and hence the value obtained is the same as before. Now, lets consider what happens to delta as the option approaches maturity, assuming that the underlying stock price doesnt change. Wkyc channel 3 tonight as Cleveland Browns Gameday Ways to watch the New Jets! This must be the case, or arbitrage opportunities would be possible. 100 days later, the forward price has changed to $1081.04. A. Unfortunately, some of the information is missing. $0.31. Also, given the single settlement date, the new swap fixed rate has to be the LIBOR rate for that settlement date, or 4.88% (given in Figure 2). a. Cox-Ingersoll-Ross model: dr = a(b r)dt + rdz Assumes the economy has a natural long-run interest rate (b) that the short-term rate (r) converges to. AValue to the payer = DF (SFRNew SFROld ) days 360 notional There is only one settlement date remaining (one year away). 209. The continuously compounded risk-free rate is 4.6% and the continuous dividend yield is 2.1%. The 30-day LIBOR is 4.5%, 90-day LIBOR is 4.7%, and 180-day LIBOR is 4.9%. B. Required CFA Institute disclaimer: CFA Institute does not endorse, promote, or warrant the The holder of a receiver swaption would exercise if market rates are less than the exercise rate at expiration. Module 41.4: Scenario Analysis and Sensitivity Analysis Required CFA Institute disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser. 1. Nath completed a partial interest rate tree shown below. 185. No part of this text may be reproduced, transmitted, downloaded, decompiled, reverse engineered, or stored in or introduced into any information storage and retrieval system, in any forms or by any means, whether electronic or mechanical, now known or hereinafter invented, without the express written permission of the publisher. In such a case, the quoted futures price is adjusted using the conversion factor for the cheapest-to-deliver bond: 1 QFP = FP/CF = [(full price)(1+ Rf )T AIT FVC] ( CF ) where: the full price = clean price + accrued interest at t = 0 AIT = accrued interest at futures contract maturity. Be able to describe how CDS are used to manage credit exposure, and how they can be used to profit from anticipated changes in the credit curve. BRemember that U.S. Treasury bonds make semiannual coupon payments, so: $1,000 0.06 C = $1,000 0.06 2 = $30.00 $30.00 1.0598/365 = $29.61 PVC = The forward price of the contract is therefore: FP (on a fixed income security) = (S0 PVC) (1 +Rf)T = ($1,044 $29.61) (1.05)120/365 = $1,030.79 (LOS 37.b) Module Quiz 37.4 1. The Washington Redskins will travel to face the Cleveland Browns on Thursday night, with kickoff scheduled for 7:30 p.m. Mississippi has suspended team activities in football during the Rebels open date. For example, for a particular portfolio, yield curve risk can be described as: P P 4x L 5x S 3xC If the following changes in the yield curve occurred: xL = 0.004, xS = 0.001, and xC = 0.002, then the percentage change in portfolio value could be calculated as: P P 4(0.004) 5(0.001) 3(0.002) = 0.005 This predicts a +0.5% increase in the portfolio value resulting from the yield curve movements. Note that while forward contracts on T-bills are usually quoted in terms of a discount percentage from face value, we use dollar prices here to make the example easy to follow. net cost = $12.28 $11.05 = $1.23 Because the market price of the put option is $1.00, arbitrage profits can be earned by selling the replicating portfolio and buying puts, for an arbitrage profit of $0.23 per put. The value of the option for the down node at t=1 is calculated as: P = (UP+ +D P) (1+Rf ) = (0.460+0.5418) (1.03) = $9.44 The value of the option at time=0 is calculated as: P= (U P+ +D P ) (1+Rf ) = (0.460+0.549.44) (1.03) = $4.95 For the down move at t = 1, the exercise value of the put option is $10, calculated as Max(0, X-S) or Max(0, 50-40). A replication portfolio for a put option consists of a long position in a risk-free bond and a short position in h shares. Statement 2 is correct. Zepo Inc. stock price is currently $80. It is important to note that effective duration is not an accurate measure of interest rate sensitivity to non-parallel shifts in the yield curve like those described by shaping risk. To correct for this, a constant spread must be added to all one-period rates in the tree such that the calculated value equals the market price of the risky bond. Using this method, we can compute the value of the call option in the up-state in period one as follows: C+ = = = E(call option value) = 1+Rf (0.6$33.13)+(0.4$5.00) (U C++)+(D C +) 1+Rf 1.07 $21.88 1.07 = $20.45 The value of the call in the down-state at t=1 is computed as: C = = = E(call option value) 1+Rf (0.6$5.00)+(0.4$0.00) = (U C+)+(D C ) 1+Rf 1.07 $3.00 1.07 = $2.80 Now we know the value of the option in both the up-state (C+) and the down-state (C) one period from now. Recall that the call option has a strike price equal to the stocks current price of $30, U = 1.333, D = 0.75, and the risk-free rate is 7%. MODULE QUIZ 37.8 To best evaluate your performance, enter your quiz answers online. e. describe market fragmentation. News, highlights, and exclusive footage for your Cleveland Browns have a 9-3 record the! B. undervalue the position by the present value of the dividends. Hence, if the firm pays a dividend during the life of the option, this must be considered in the valuation formula. the return on the tracked index. CFA Program Curriculum, Volume 5, page 81 The binomial interest rate tree framework assumes that interest rates have an equal probability of taking one of two possible values in the next period (hence the term binomial). The general form for the calculation of the forward contract price can be stated as follows: FP = S0 (1 + Rf) T or S0 = FP (1+Rf ) T where: FP =forward price S0 = spot price at inception of the contract (t = 0) Rf = annual risk-free rate T = forward contract term in years EXAMPLE: Calculating the no-arbitrage forward price Consider a 3-month forward contract on a zero-coupon bond with a face value of $1,000 that is currently quoted at $500, and suppose that the annual risk-free rate is 6%. (LOS 35.b) 4. Discount the expected option payoff (t = 2) back one period at the risk-free rate to find the option values at the end of the first period (t = 1). Use the following information to answer questions 1 through 6. Compared to effective duration, key rate duration is superior for measuring the impact of nonparallel yield curve shifts. Similarly, for a putable bond, the value used at any node corresponding to a put date must be either the price at which the investor will put the bond (i.e., the put price) or the computed value if the bond is not put, whichever is higher. Because the probabilities of an up move and a down move are both 50%, the value of a bond at a given node in a binomial tree is the average of the present values of the two possible values from the next period. Calls can be thought of as a leveraged stock investment where N(d1) units of stock are purchased using erTXN(d2) of borrowed funds. Several of his clients have fixed income positions, and one of Honnys analysts has advised him that the firm could improve the performance of these portfolios through swaps. MODULE 38.7: OPTION GREEKS AND DYNAMIC HEDGING LOS 38.k: Interpret each of the option Greeks. CThe swap market is not controlled by governments, which makes swap rates more comparable across different countries. B. a. describe objectives in backtesting an investment strategy. When Dixon asks about term structure of interest rates, Song mentions that he had attended a seminar on that topic at university the previous semester. $0.01166 B. What will be the payoff on the CDS? Good luck everyone, [Level 2 Notes Part #2] (https://www.dropbox.com/s/khi7mln1l0g3bpt/CFA%202018%20L2%20Econ.pdf?dl=0), Relevance of Questions from past Level III Essay Exams. Given a recovery rate of 45%, what is the IRR on the bond if it defaults in year 2? LOS 34.f A backwards induction process is used in a binomial interest rate tree framework for valuing a callable (or putable) bond. h. explain how the phase of the business cycle affects short-term and long-term A bank entered into a $5,000,000, 1-year equity swap with quarterly payments 300 days ago. Heres how it is done: Step 1: Given assumptions about benchmark interest rates, interest rate volatility, and any calls and/or puts, calculate the OAS for the issue using the current market price and the binomial model. B. Figure 32.3: Spot and Future Rates Notice that in this example, because short-term rates are expected to rise (from 5% to 9%), the yield curve will be upward sloping. Contents 1. When the spot curve is upward sloping (downward sloping), forward rate curves will be above (below) the spot curve and the yield for a maturity of T will be less than (greater than) the spot rate ST . Green heads a team that inputs raw data into an instructional area on FIDatas website. After inception, the credit quality of the reference entity (or the credit risk premium in the overall market) may change. When the yield curve is upward sloping (i.e., normal), the more distant one-period forward rates are higher than the one-period forward rates in the near future. EXAMPLE: Hedging with call options, part 1 Suppose you own 60,000 shares of Arthurall Company common stock that is currently selling for $50. Figure 37.2: Reverse Cash and Carry Arbitrage When Forward Is Underpriced Today Spot price of bond Forward price Transaction Long forward Short sell bond Invest short-sale proceeds at 6% Total cash flow Three Months From Today $500 $502 Cash flow $0 +$500 $500 $0 Transaction Settle long position by buying bond Deliver bond to close short position Receive investment proceeds Total cash flow = arbitrage profit Cash flow $502.00 $0.00 +$507.34 +$5.34 In this case, because the forward contract is underpriced, the trades are reversed from cash and carry arbitrage. One of the key assumptions of the structural model is that the assets of the company are traded in the market. Figure 35.4: U.S. Treasury and High-Quality Corporate Bond Yields Source: St. Louis Federal Reserve Bank, May 2018. b. explain the ethical responsibilities required of CFA Institute members and If given the current forward price (FPt) on the same underlying and with the same maturity: Vt(long position) = [ FPt FP (1+Rf )Tt ] EXAMPLE: Calculating the value of an equity forward contract on a stock After 60 days, the value of the stock in the previous example is $36.00. You can also download it, export it or print it out. ANSWER KEY FOR MODULE QUIZ Module Quiz 36.1, 36.2, 36.3 1. Hence, less liquid maturities would show higher spreads (even if the expectations for that time period are stable). Key determinants of the shape of the credit spread curve include expectations about future recovery rates and default probabilities. B. 3. CLets construct a table of the risk differences between the issuers callable bond and on-the-run Treasuries to help us answer this question. 2. Path Year 1 Year 2 Year 3 Value 1 2 3 4 3% 3% 3% 3% 5.7883% 5.7883% 3.8800% 3.8800% 10.7383% 7.1981% 7.1981% 4.8250% Average $91.03 $93.85 $95.52 $97.55 $94.49 For example, the value of the bond in Path 1 is computed as: value1 = 3 (1.03) 3 103 + (1.03)(1.057883) + (1.03)(1.057883)(1.107383) = $91.03 LOS 33.h: Describe a Monte Carlo forward-rate simulation and its application. After 300 days, the 60-day $ interest rate is 5.4%, the 60-day interest rate is 6.6%, and the exchange rate is 0.52 per $. (page 125) e. describe the use of CDS to take advantage of valuation disparities among separate markets, such as bonds, loans, equities, and equity-linked instruments. All online tools are available in your account through our Learning Platform. The lending rate on dollar-denominated loans between banks is called the London Interbank Offered Rate (LIBOR). Answer: FP = 1,140 e(0.046 0.021)(140/365) = 1,151 On a TI BA II PLUS calculator, use the following keystrokes: 0.046[]0.021[=][]140[]365[=][2nd][LN][]1140[=] MODULE QUIZ 37.1, 37.2 To best evaluate your performance, enter your quiz answers online. REDUCED FORM MODELS Reduced form (RF) models do not rely on the structure of a companys balance sheet and therefore do not assume that the assets of the company trade. However, to understand the pricing and calculation of value for an FRA, viewing the contract as a commitment to lend or borrow at a certain interest rate at a future date is helpful. Therefore, when a The beginning stock value of $30 is to the left, and to the right are the two possible paths the stock can take, based on that starting point and the size of an up- or down-move. If we use the label of S for the one-period spot rate and U and L for upper and lower outcomes, respectively, for forward rates in our binomial framework, the four paths would be SUU, SUL, SLU, and SLL. Answer: B. (page 22) m. explain the maturity structure of yield volatilities and their effect on price volatility. C. optimized. Expected Loss Year Exposure LGD PD PS 1 2 3 106.89 42.756 104.00 41.600 1.00% 0.99% 0.98% 99.000% 98.010% 97.030% 0.428 0.408 DF 0.9756 0.9518 0.9286 PV of Expected Loss 0.42 0.38 The CVA on the bond is closest to: A. Topic Assessment Answers: Fixed Income 8. C. a loan level analysis. Each forward rate is related to (i.e., is a multiple of) the other forward rates in the same nodal period. When: Thursday, September 17 ; time: 8:20 p.m in third Cleveland Browns the preseason tonight when they host the Detroit Lions at Stadium! A call option on an FRA gains when rates rise, and a put option on an FRA gains when rates fall. Module 24.1: Equity Valuation: Applications and Processes 3. Figure 33.1: Binomial Interest Rate Tree To understand this two-period binomial tree, consider the nodes indicated with the bold dots (). READING 33: THE ARBITRAGE-FREE VALUATION FRAMEWORK Study Session 12 EXAM FOCUS This topic review discusses valuation of fixed-income securities using spot rates as well as using the backward induction methodology in a binomial interest rate tree framework. 02) (1. Conversion price Current stock price Convertible Bond ABC $40 $123 Convertible Bond XYZ $50 $8 Which factors are most likely to influence the market prices of ABC and XYZ: factors that affect equity prices, or factors that affect option-free bond prices? 208. Because the $1 cash flows at j+k are the same, these two investments should have the same price, which leads to the forward pricing model: P(j+k) = PjF(j,k) Therefore: F(j,k) = P(j+k) Pj EXAMPLE: Forward pricing Calculate the forward price two years from now for a $1 par, zero-coupon, three-year bond given the following spot rates. Therefore, a change in the forward price indicates that the future spot rate(s) did not conform to the forward curve. This change in methodology computes the value of the bond at different points in time; these checks are necessary to determine whether the embedded option is in-the-money (and exercised). Module 34.1: Types of Embedded Options 3. Interest rate parity is based on a no-arbitrage condition: a higher interest rate currency will trade at a forward discount to offset the extra interest income. However, OAS estimation for callable bonds can be biased upward if the analyst uses too high an estimate of interest rate volatility. Song says that an analyst could use structural models to analyze credit risk of Zena, Inc., bonds, and that one of the ways to evaluate credit risk is to look at the economic exposure of the equity investors. C. the mean cumulative present value of expected loss. The statement credit spreads are positively related to loss given default and to hazard rate is: A. correct. An active portfolio manager will try to outperform the overall bond market by predicting how the future spot rates will differ from those predicted by the current forward curve. LOS 35.h Credit analysis of ABS involves the analysis of the collateral pool, servicer quality, and the structure of secured debt (i.e., distribution waterfall). This measure provides an indication of the ETFs ability these Notes. Using the information in Figure 1, the value of a three-year, 3% annual-pay benchmark bond under Path 1 and Path 2 is closest to: Path 1 Path 2 A. Coverage on the Cleveland Browns have a 9-3 record after the first quarters Start of any season, there is plenty of excitement about the year ahead to to For 7:30 p.m schedule, channel for Browns vs. Bengals in Week 2 `` monday football. 189. Carlo simulation methods for estimating VaR. We illustrate the computation of CVA in the example below. 94. Redskins football has finally arrived, as they travel to Cleveland to take on the Browns in their 2019 preseason opener. 1. Calculate the yield to maturity (y3): N = 3; PV = 922.64; PMT = 40; FV = 1,000; CPT I/Y 6.94 y3 = 6.94% Note that the yield on a three year bond is a weighted average of three spot rates, so in this case we would expect S1 < y3 < S3. SCHWESERNOTES 2020 LEVEL II CFA BOOK 4: FIXED INCOME AND DERIVATIVES 2019 Kaplan, Inc. All rights reserved. 126. (LOS 38.n) 4. CFA Program Curriculum, Volume 5, pages 386, 388, and 408 BINOMIAL MODEL A binomial model is based on the idea that, over the next period, the value of an asset will change to one of two possible values (binomial). Under a high volatility assumption, we would already have a lower computed value for the callable bond, and hence, the additional spread (i.e., the OAS) needed to force the discounted value to equal the market price will be lower. (Plug Z = 0.008 into the right-hand-side of the equation above to reassure yourself that the present value of the bonds cash flows equals $104.12). Answer: [1 + f(j,k)]k = [1 + S(j+k)](j+k) / (1 + Sj)j [1 + f(2,3)]3 = [1 + 0.06]5 / [1 + 0.04]2 f(2,3) = 7.35% Note that the forward rate f(2,3) > S5 because the yield curve is upward sloping. These bounds are based on the notion of mean reversion; rates tend to rise when they are too low and fall when they are too high. They are the risk-neutral probabilities that are consistent with investor risk-neutrality. Which of the advantages of the Monte Carlo method stated by Dane is most accurate? The bottom line is that a put options delta will increase from e T to 0 as stock price increases. A Dixon is correct about callable bonds exhibiting negative convexity. Answer Key for Module Quizzes BUse the dividend rate as a continuously compounded rate to get: FP = 540 e(0.07 0.018) (200 / 365) = 555.61 (Module 37.2, LOS 37.b) 4. $1,030.79. CBuying convertible bonds in lieu of direct stock investing limits downside risk to that of straight bond investing, at the cost of reduced upside potential due to the conversion premium. If the binomial lattice is correctly calibrated, it should give the same value for an option-free bond as using the par curve used to calibrate the tree. 54. issuer (i.e. Accordingly, she should buy the calls. A. Similarly, when the analyst uses a lower-than-actual (higher-than-actual) level of volatility, the computed OAS for a putable bond will be too low (high) and the bond will be erroneously classified as overpriced (underpriced). Module 37.1: Pricing and Valuation Concepts 3. CThe value of a comparable risk-free bond (using the benchmark rate of 2.50%) can be calculated to be $107.41 as follows: N = 3, PMT = 5, FV = 100, I/Y = 2.50, CPT PV = 107.14. Vanessa Alwan, an intern, has suggested a list of bonds for Osagaes consideration as shown in Figure 1. The sum of the PV of expected loss column is the CVA = 2.41. When the yield curve is upward sloping, the probability of the put option going in the money is higher. It shouldthats also the definition of delta. CFA Program Curriculum, Volume 5, page 145 Video covering this content is available online. The underlying asset price follows a geometric Brownian motion process. The notional principal attributable to entity A is $100 million / 125 = $0.8 million. For bonds with embedded options, one-sided durationsdurations that apply only when interest rates rise (or, alternatively, only when rates fall)are better at capturing interest rate sensitivity than simple effective duration. What's app no. Figure 35.5 shows the resulting HQM spread curve. Step 4: Add the OAS from step 1 to each of the one-year rates in the interest rate tree to get a modified tree. & schedule information for the Cleveland Browns coronavirus cases what TV channel for football is over! Effective Duration Effective duration measures price sensitivity to small parallel shifts in the yield curve. Suppose that after 180 days, the LIBOR term structure is flat at 3.5% over the next year. The local expectations theory can be shown not to hold because the short-holding-period returns of long-maturity bonds can be shown to be higher than short-holding-period returns on short-maturity bonds due to liquidity premiums and hedging concerns. The following information relates to questions 1 through 5. $4.16. Reading 36: Credit Default Swaps 1. BWhen interest rates increase, a callable bond becomes less likely to be called (its duration will increase). What will be the notional principal of the CDS after default? AImplied volatility is the volatility that produces market option prices from the BSM model. Module 41.1: Introduction to Backtesting A synthetic European put option is created by: A. buying the discount bond, buying the call option, and short-selling the stock. b. compare the parametric (variancecovariance), historical simulation, and Monte We offer the latest on your favorite NFL teams on CBSSports.com here is everything need. Because structural models assume a simple balance sheet structure, complex balance sheets cannot be modeled. Answer: FT (currency forward contract) = $0.0845 1.06180/365 1.08180/365 = $0.0837 Valuing Currency Forward Contracts After Initiation After inception, currency forward contracts can be valued as: Vt = [FPt FP] (contract size) (1+rPC) (Tt) where Vt = value (in price currency units) to the party long the base currency FP = forward price at inception of the contract maturing at time T (in PC/BC) FPt = forward price at time t (t < T) of contract maturing at T rPC = interest rate of the price currency EXAMPLE: Calculating the value of a currency forward contract David Hastings entered into a four-month forward contract to buy 10 million at a price of $1.112 per euro. 212. WebMake any adjustments required: add text and images to your Schweser cfa level 2 2022 pdf download, underline details that matter, erase sections of content and substitute them with As there is no initial investment, the gains cannot be measures as percentage of initial cost. h. describe comparative advantages of low-latency traders. Calculate the amount the PPN issuer paid Martha when the PPN matured. f. describe uses of multifactor models and interpret the output of analyses based on (page 24) The topical coverage corresponds with the following CFA Institute assigned reading: 33. Answer: The value to the long party is given by: Vt = = [FP tFP](contract size) (1+rPC )(Tt) [1.1091.112]10,000,000 (1.003)( 0.25) = 29,978 USD The value of the forward position is negative to Hastings, as the forward price of euros has dropped since the contract initiation. MODULE QUIZ 35.1 To best evaluate your performance, enter your quiz answers online. The notation for FRAs is unique. CFA Level 2 Kaplan Schweser Study Package (5 Syllabus Books+2 Practice Books) (Paperback, Kaplan) BookCFA Level 2 Kaplan Schweser Study Package (5 Syllabus Books+2 Practice Books)Publishing Date2019PublisherKSEdition2Number of Pages12003 more rows. C. equal to 145 bps. B. a portfolio-based approach. The present value of the difference between the standardized coupon rate and the credit spread on the reference obligation is paid upfront by one of the parties to the contract. a. describe arbitrage pricing theory (APT), including its underlying assumptions and Consider a two-year, semiannual interest rate swap. That comes down to about 15 hours per week, especially since youre likely working full time while studying. 2. P0 = (UP++DP ) (1+Rf ) = (0.460+0.5410.0) (1.03) = $5.24 American-style call options on dividend-paying stocks can be evaluated similarly: determine at each node whether the exercise value is greater than the intrinsic value and, if so, use that higher value. Estimate the forward rate indicated by C. 3. LOS 33.b Arbitrage-free valuation of fixed-rate, option-free bonds entails discounting each of the bonds future cash flows at its corresponding spot rate. value of a capped floater = value of a straight floater value of the embedded cap A related floating rate bond is the floored floater, which has a coupon rate that will not fall below a specified minimum rate known as the floor. After the initiation of an interest rate swap, the swap will take on a positive or negative value as interest rates change. C. Swap rates are comparable across different countries because the swap market is not controlled by governments.

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