Fixed Income Securities Essay

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1. Briefly explain why many corporations prefer to publish callable long-run corporate bonds instead than noncallable long-run bonds.

There are three chief grounds why a corporation may be interested in naming a bond. * Interest rated have fallen. so they can refinance at a lower rate. * Credit quality has improved. so they can refinance at a lower rate. * Assetss have been sold. so money is available to pay off debt.

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2. Briefly explain the thought behind an Immunized Chemical bond Portfolio.

With an Immunized Portfolio. the continuance and convexness of the assets is set to fit the continuance and convexness of the liabilities. The PV of the assets is set greater than the PV of the liabilities. For little alterations in output. the plus value should increase or diminish proportionately to the alterations in the value of the liabilities. This method insures that the return on the assets and the return on the liabilities remain the same. Another manner of looking at it is that immunisation sets the monetary value hazard precisely equal to the reinvestment hazard.

3. Explain why an Interest Merely Strip ( IO MBS ) normally additions value when involvement rates increase.

IO Strips receive the involvement part of a MBS. If involvement rates decrease. so prepayments should rush up. If this happens. so smaller payments are received in the hereafter. While these smaller payments are discounted at a lower rate. the net consequence is normally a lessening in value.

4. Briefly explain what happens to the monetary value of a consecutive bond ( no options ) when the output increases – and why.

Monetary value goes down when outputs go up. I needed you to state me why. I accepted any of the three grounds from the Bond Analytics talk notes.

5. Briefly describe how the Federal Reserve moves rates in the Federal Funds Market.

The Federal Reserve can non merchandise in the Federal Funds Market. However. Bankss have other options for raising hard currency to lodge with the Federal Reserve. The Fed can merchandise in those markets to alter outputs. The Repo Market is their most common tool. though they can besides alter the Discount Rate for borrowing financess from the Fed. In add-on. they can alter the Reserve Requirements.

6. Suppose that you want to fudge the involvement rate hazard of a Fixed Income Security that has negative convexness. Suppose that you can make a perfect hedge with hereafters and options ( paying a premium to purchase the options ) . As an option. you can utilize hedge with hereafters entirely. If you believe that the true volatility will be much lower than the implied volatility of the options. which alternate should you take? Why?

If you believe that the implied volatility of the options is excessively high. so you would besides believe that the options are overpriced. It would be cheaper to fudge with hereafters entirely if you are right.

7. Briefly explain the thought behind dividing a comrade CMO tranche into a drifting rate category and an reverse rate drifting rate category.

Interrupting the comrades into a musca volitans and reverse musca volitans does non alter the prepayments – but affects the degree of hazard associated with it. Musca volitanss have really small monetary value hazard – so prepayments do non hold much of an consequence on monetary value ( unless there is a low cap ) . There is reinvestment hazard for musca volitanss. but those puting in musca volitanss will non mind prepayments. since they are reinvested at a similar rate. Inverse Floaters will be really sensitive to prepayments. However. faster prepayments increase the values. In add-on. these are extremely bulging. long continuance instruments. so they can be hedged with hereafters. Many people merely discussed the Floater and neglected to discourse the Inverse Floater. Many said that if the cap is hit. these become fixed hard currency flow bonds ( so less hazard ) . They do non. They become fixed rate bonds that have a batch of prepayment hazard. Several people mentioned the cap being a present value ( despite the fact that I warned about this in category ) . It is calculated to a preset value.

8. Suppose that a fixed hard currency flow exchequer bond is split into two bonds. a musca volitans and an reverse musca volitans. Briefly explain why the Inverse Floating Rate Bond has a much longer effectual continuance than the implicit in fixed hard currency flow.

If rates increase. so both bonds lose value because they are discounted at a higher rate. But the reverse Floater will besides lose value because the voucher payments lessening. The opposite holds when rates decrease. Therefore. the monetary value impact is greater for Inverse Musca volitanss than for Straight Bonds.

Note that there is another manner to believe of this. A portfolio made up of an reverse musca volitans and a musca volitans must hold the same continuance as a fixed hard currency flow bond. Since the musca volitans has a really short continuance. the reverse musca volitans must hold a longer continuance than the norm.

9. Briefly explain why Salomon Brothers was able to do a net income while they were squashing the Biennial Treasury.

Salomon Brothers operated in four markets.

1. They paid a little more than the just monetary value for the bonds in the Primary Market. but that allowed them to command the issue. In order to make this they illicitly bought more than they were allowed to purchase. 2. They paid a just monetary value in the When-Issued market. Making so gave them even greater control over the issue. 3. They charged a higher than just monetary value in the Secondary Market. They sold the issue easy in order to keep the premium. 4. The loaned the security in the Repo Market at particular rates. Others had to present that peculiar bond. so would be forced to impart money at low rates.

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