You are on page 1of 38

TERM STRUCTURE AND VOLATILITY OF INTEREST RATES 1. Yield curves a. Normal LT rates > ST rates b.

. Flat yield on all maturities essential same. c. Inverted LT rates < ST rates.

2. Shifts of yield curves a. // : yields on all maturities change in same direction by same amount. Slope of curve unchanged. b. Non-// : yields for various maturities change by differing amounts. i. Twists: slope becomes flatter (slope between ST and LT rates narrow) or steeper (spreads widen). ii. Butterfly Shifts: changes in degree of curvature. +ve means become less curved where ST and LT yields increase by more than intermediate yields. ve means more curvature.

3. Factors driving US Treasury security returns a. Changes in I/R levels (// shift) - Greatest contribution to explain variance in zero-coupon T securities return b. Changes in slope (twists) Explain smaller % of returns variance on all maturity levels. c. Changes in curvature (butterfly) Least contribution 4. Duration a. Since duration measures (3a), useful to quantify i/r risk. b. Key rate duration (non // shifts) supplement info from duration. 5. Pricing of fixed income security a. Spot rate rate prevailing today for zero coupon bond with same maturity as cash flow being valued b. Eg. To value 6 year 9% bond, need unique spot rates for each of 14 coupon payments and principal construct theoretical spot rate curve c. Bootstrapping is process of sequentially calculating spot rates from securities with different maturities, using yields on T-bonds i. Eg. 6-mth US T-bill has 4% annualised yield, 1-yr T-STRIP has 4.5% annualised yield. Given 1.5-yr T priced at $95.

6. T-securities used to construct spot rate curve a. On-The-Run T-Securities newest T issues of given maturity. i. Largest trading vol most accurately priced. ii. Not appropriate to use due to tax effects on premium priced and discounted onthe-run coupon instruments iii. Soln: Compute yield when trade at par linear extrapolate missing maturities to get on-the-run yield curve (par coupon curve) bootstrap spot rate curve. iv. Advantage: use only most accurately priced issued. v. Disadvantage: large maturity gaps after 5-year note. b. On-The-Run + off-the-Run T-Securities i. On-the-run only create problems as not available for every maturity. ii. Soln: Add 20 and 25 year off-the-run issues linear extrapolate missing maturity bootstrap spot rate curve. iii. Advantage: reduce maturity gaps iv. Disadvantage: Still doesnt use all rate info contained in T-issues; Rates may be distorted by repo market c. T Coupon Securities and Bills i. In response to (6biv), use all T coupon securities and bills to construct spot rate curve. ii. Cant use bootstrap as more than one yield may exist for each maturity. iii. Advantage: Does not ignore info from issues excluded by other approach iv. Disadvantage: some maturities have more than one yield; current prices may not reflect accurate i/r for all maturities. d. T Strips

i. Zero coupon securities made by stripping coupons from normal T-bonds. ii. Strips market less liquid than T-coupon market, so strip rates include liquidity premium. iii. T-strips reflect tax disadvantage as accrued interest is taxed even though no CF realised. iv. Some non-US tax laws allow investors to recognise difference between maturity value and price of principal strips as favourably taxed capital gain. v. Advantage: Provide yields at most maturities and reduce gaps; Intuitive approach that does not require bootstrap to derive spot rates. vi. Disadvantage: Liquidity premium; tax treatment 7. Swap Rate Curve (LIBOR curve) a. Series of swap rates quoted by swap dealers over maturities from 2-30 years b. Swap spreads reflect only credit risk of counterparty (usually bank), so AA-rated curve, not default-free curve. c. USD LIBOR refers to swap rates in which one party pays fixed swap rate in USD d. Preferred as benchmark i/r curve rather than govt bond yield curve: i. Swap market not regulated by govt ii. Supply of swaps and equilibrium pricing depends only on number of participants. Not affected by technical market factors that can affect govt bonds. iii. Swap curves across countries more comparable as reflect similar levels of credit risk while govt bond yield also reflect sovereign risk unique to country iv. Yield quotes at 11 maturities between 2-30 years while US govt bond yield curve only on-the-run issues for 4 maturities. 8. Pure(Unbiased) Expectation Theory a. Forward rates are solely function of expected future spot rates. LT i/r = mean of future expected ST rates. i. Eg. 1 year spot is 5%, 2 year spot is 7%. Therefore, 1 year forward = 9%

b. If yield curve upward sloping, ST rates expected to rise. c. Flat curve means market expected ST rates to remain constant. d. Implied forward rate (9%) i. Breakeven rate forward rate that leaves investors indifferent between investing for 2 years or invest for one year and reinvest at breakeven forward rate for second year.

ii. Locked-in rate for future Invest in two year bond to lock in a 9% rate for 1 year period starting in 1 year. iii. Expected spot rate in one year = implied 1 year forward rate. e. Disadvantage: fail to consider riskiness of bond investing i. Price risk uncertainty associated with future price of bond that may be sold prior to maturity. ii. Reinvestment Risk uncertainty associated with rate at which bond cash flows can be reinvested over investment horizon. 9. Liquid Preference Theory a. Forward rates reflect investors expectations of future spot rates plus liquidity premium to compensate for exposure to i/r risk. b. Liquidity premium is required to induce investors to hold 2 year bond instead of two 1 year bonds and is higher for longer-term investments. c. Liquidity premium may not be constant (larger when greater economic uncertainty and risk aversion higher) d. Positive sloping curve: i. Market expects future i/r to rise ii. Rates expected to remain constant or fall, but addition of premium results in positive slope. e. Downward sloping curve: falling ST rates f. Eg. Expected spot rate in 2nd yr is 8%, 2 year spot rate is 7%.

10. Preferred Habitat Theory a. Similar to liquid preference but dont support view of premium related to maturity. Able to explain almost any yield curve shape. b. Imbalance between supply and demand for funds in given maturity range induce lenders and borrowers to shift preferred habitats (maturity range) to one with opposite imbalance need incentive to compensate for exposure to price and/or reinvest risk in less-than-preferred habitat. c. Borrowers need cost savings (lower yields) and lenders yield premium (higher yields) to move out of preferred. 11. Duration adequate measure of bond price risk only for small // shifts in yield curve. 12. Key rate duration measures non-// shifts. a. Rate duration - Sensitivity of value of security/portfolio to change in single spot rate, holding all others constant. b. Every security/portfolio has set of key rate durations, one for each key rate (every maturity on spot rate curve) c. Key rate duration approx. % change in value of bond/portfolio in response to 100 bps change in corresponding key rate, holding all others constant.

d. Effective duration of portfolio is weighted average of key rate durations of individual security durations, where weights based on market value of each bond relative to portfolio market value. i. Eg. Effective portfolio duration is 17.7, if yield curve // shift up by 100 bps, value of portfolio decline by 17.7 x 1% = 17.7% 13. Bond portfolio structure a. Barbell large % of long and short maturity bonds b. Ladder bonds evenly distributed throughout maturity spectrum c. Bullet high concentration of bonds at some intermediate maturity. 14. Historical Yield volatility measurement a. Measured by standard deviation of daily yield changes. b. Continuously compounded yield changes are natural log of ratio of yield levels. c. Choice of sample period depends on investment horizon of user (day traders focus on recent week or two, bond portfolio managers look at past month or longer)

d. Eg. annualised std dev of 10%. If portfolio yield is 8%, std dev is 80 bps (8% x 0.1). i. If yield changes normally distributed, 68.3% probability observed yield will be +/one std dev (7.2% - 8.8%) from expected yield. 15. Implied Yield Volatility a. Estimated using observed prices for i/r derivatives and option pricing models. b. Plug observed option price into model then solve for unknown volatility (std dev) c. Disadvantage: i. Based on assumption that option pricing model is correct ii. Assume that volatility is constant 16. Forecasting Yield Volatility a. Use zero value for expected change in yields and incorporate weights

b. Yield volatility has been observed to follow patterns over time. Can be forecasted based on autoregressive conditional heteroskedasticity (ARCH) models. GENERAL PRINCIPLES OF CREDIT ANALYSIS 1. Credit Risk a. Default Risk borrower will not repay obligation b. Credit Spread Risk credit spread increase and cause issue value to decrease and/or bond to underperform benchmark. c. Downgrade Risk issue downgraded by credit rating agencies causing bond price to fall and/or underperform benchmark 2. Rating Agencies a. Standard & Poors, Moodys, Fitch b. Only assess default risk through: i. Credit Rating For LT debt, reflect default rate (probability of default) and default loss rate (loss to investor if default occurs). For ST debt, reflect only probability of default. ii. Rating Watch announce reviewing particular issue in advance of potential up/downgrade in ST (eg. 3 mths) iii. Rating Outlook LT projections (6 mths 2 yrs) of whether issue likely to be upgraded (+ve outlook), downgraded (-ve outlook) or keeps current rating (stable outlook) c. Moodys suggestion for analysis: i. Downgrade watch - reduce current rating by two notches ii. Negative outlook reduce current rating by one notch iii. Positive outlook increase current rating by one notch iv. Upgrade watch increase current rating by two notches 3. Character a. Managements integrity, commitment to repay loan, biz qualification, operating record, ability to react to unexpected events. b. Managements strategic direction, financial philosophy, conservatism, track record, succession planning, control systems. c. Corporate Governance i. Larger board reduces CEO influence and allows for separate auditing, compensation, nominating committees ii. Majority should be independent directors and 3 committees in 3ci should be composed entirely of independent directors. iii. Nominating committee (not CEO) should be responsible for identifying new board members iv. CEO should not be Chairman of board. 4. Covenants a. Terms and conditions borrowing & lending parties agree to as part of bond issue b. Affirmative: require debtor to take actions i. Pay interest, principal, taxes

ii. Comply with loan agreements and maintain properties c. Negative: prohibit borrower from taking actions. i. Maintain ratios, levels of cash flow and working capital ii. Limitations to incur additional debt, dividend payments, stock repurchase, borrowings by subsidiaries d. For analysis: i. Whether covenants protect interest of bondholder while not unduly restricting operating and strategic decisions of borrower. ii. Especially important for high-yield issues 5. Collateral a. Assets offered as security for debt and other assets controlled by issuer b. Secured with pledge of assets or unsecured c. Priority of secured claim is sometimes questionable under US bankruptcy law. Hence, least useful in assessing corporate credit risk. 6. Capacity to Pay a. Borrowers ability to generate cash flow or liquidate ST assets to repay debt obligations. b. Moodys assessment: i. Industry trends ii. Regulatory environment iii. Operating and competitive position iv. Financial position and sources of liquidity, company structure, parent company support agreements, special event risk c. Sources of Liquidity: i. Working capital (CA-CL). High solvency ratios = greater capacity to repay. ii. Steady, dependable cash flow. iii. Back-up facilities and relative strength of each. Eg. Lenders ability to refuse funds provision for credit line. iv. Securitising assets as substitute for ST bank debt. v. Additional third-party guarantees require credit analysis of that entity. 7. Credit Analysis with Ratios a. Rating agencies specify ratio ranges for each debt rating. Through analysis, identify candidates for downgrading. b. Profitability issuers ability to generate earnings to pay interest and repay principal. i. ROE (DuPont)

c. ST Solvency Ratios firms ability to repay ST debt obligations by liquidating ST assets. i. Use industry averages as benchmark. ii. If firm is greater than industry, better ability to repay.

d. Capitalisation (financial leverage) firms ability to take on additional risk associated with increased borrowing. i. Use industry average as benchmark. ii. If firm is greater than industry, less capacity to take on more LT debt. iii. Should also adjust LT debt to reflect PV of operating lease future payments.

e. Coverage Ratios firms ability to repay debt and lease obligations out of CFO i. Ratios include capitalised interest ii. May fluctuate widely over time firms with more stable, comfortable ratios are more creditworthy

8. Cash Flow Analysis critical as it is primary source of debt repayment. a. S&P analysis

b. 4 ratios + debt svc coverage higher better. Debt payback lower better.

High-yield issues focus on two particular areas: 9. Debt structure a. Bank debt, reset notes, senior and subordinated debt b. High-yield borrowers typically rely on bank debt more than investment-grade borrowers. i. As bank debt is floating rate, CF analysis under different i/r scenario needed. ii. As bank debt is ST, determine how and where to get funds 1. If source is CFO, CF projection crucial 2. If repayment from refinancing, analysis of capital market condition necessary 3. Assess effect on future CF of firms plans to sell assets to pay off bank debt. Asset sales generate cash today to pay down ST debt but may reduce future CF to pay LT debt. iii. As bank debt is senior, has higher claim against firms assets than senior debt. ie. Senior high-yield debt is subordinate to bank debt. c. Reset notes trade at premium to par value as coupon rate adjusted periodically. i. Effects of changing credit spreads must be incorporated in i/r scenario ii. Firm may sell assets to avoid higher interest costs on reset notes if rates/spreads rise need to analyse effects of asset sales on future CF. d. Relative amount of zero-coupon bonds in debt structure. i. As unpaid interest to bonds accrue over time, relative proportion of bonds in debt structure increases relative to subordinated issues if bonds senior to subordinated issue, credit risk of subordinated increase. 10. Corporate structure a. High yield issues often structured as holding coy. b. Debt borrowed at parent level and funds to pay obligation obtained from operating subsidiaries. c. Important that subsidiaries financial ratios examined to determine if can help parent meet obligations and whether subsidiaries own debt covenants will restrict cash contributions. i. Eg. restrictions on dividend payments to parent? ii. Intercompany loans permitted? iii. Restrictions on asset sales? 11. Asset-backed Securities Credit Analysis a. Collateral Credit Quality i. Single most important issue for ABS and MBS (non-agency mortgage-backed securities) ii. Able to provide CF to pay principal and interest over life of issues in assetbacked structure iii. Concentration of loans in collateral pool. Small loans reduce total credit risk through diversification. b. Seller/Servicer Quality i. Responsible for administrative functions collecting payments, notifying issuer of delinquencies, recover and liquidate collateral

ii. Distributes CF from collateral pool to bondholders in ABS. May advance payments during temporary CF shortages. iii. Assess performance history, experience, underwriting standards adopted for loan originations, servicing capabilities, financial strength, growth relative to competitive and business environment. iv. True securitisation - Servicer role exclusively administrative v. Hybrid transaction Servicer role go beyond administrative. Analysis focus on ABS evaluation (quality of collateral pool) and servicer evaluation (corporate credit analysis). As servicer role in CF generation increase, significance of servicer credit quality higher. c. CF stress and payment structure i. Analyse CF projections under different scenarios related to losses, delinquencies, economic conditions assess how CF distributed to various tranches. ii. CF may only be sufficient to meet CF requirements of some, not all, ABS tranches. d. Legal Structure i. Use SPV to hold collateralised assets in event of bankruptcy, courts will not apply CF from collateral toward satisfaction of general corporate liabilities enable assets to get higher credit rating than firm. 12. Municipal Bond Credit Analysis a. Tax-backed debt issued by municipalities and secured with tax revenue i. Issuers debt structure debt per capita in tax jurisdiction; debt as % of total real estate value of properties subject to tax and residents personal incomes. ii. Budgetary Policy balanced budget over 3-5 year is indicative of financial and political discipline. iii. Local tax and intergovt revenue availability Evaluate tax collection rates and historical info concerning local rev sources + secondary sources of state govt support to determine repayment capacity. iv. Issuers socioeconomic environment Evaluate trends in local employment level and eco environment to assess stability of revenue base and future potential to service debt. b. Revenue Bonds to finance specific projects and enterprises. Pledge revenue generated by project for loan repayment i. Limits of basic security trust indenture explains how project rev may be limited by federal, state and local govt. Limitations reduce bonds credit quality. ii. Flow of funds structure net rev after operating expenses rev goes to revenue fund from which expense disbursements made in order: operations and ordinary maintenance, debt service, major repairs and equip replacement, extraordinary maintenance. Need to look at deviations from this structure where rev can first be applied to general obligations of issuing municipality reduce credit quality of bonds. iii. Rate/user charge covenants specifies how prices will be set on product/service provided by issuer. Ensure enterprise has sufficient CF to meet expenses and service debt. improves credit quality

iv. Priority-of-revenue claims can other entities legally redirect project CF prior to application to operating cost and debt service? v. Additional bonds test Covenant that sets out conditions under which municipality can issue additional debt with same claim against project revenues. Tighter restrictions higher credit quality. Sovereign Bond Credit Analysis 13. S&P focus on: a. Economic Risk ability of govt to meet its debt obligations.

b. Political Risk willingness of govt to meet debt obligations. Important as usually no legal recourse if issuer refuse to pay.

14. Local and Foreign Currency Debt Ratings a. Each govt issued two ratings: Separate cuz defaults on foreign-currency denominated debt historically exceeded that of local. b. Foreign higher default as govt must purchase foreign currency in open market to make interest and principal payments expose to risk of significant local currency depreciation. c. Local can be repaid by raising tax or controlling domestic spending. d. Local ratings: i. Political stability and extent of populace participation in political process ii. Income base and growth along with eco infrastructure iii. Tax discipline and budgetary record iv. Monetary policy and rate of inflation v. Govt debt burden and debt service experience e. Foreign ratings: i. Domestic vs foreign govt economic and fiscal policies ii. Bal of Payments and Composition of external bal sheet relative to external debt obligations.

15. Comparisons of Corporate Bonds Credit Analysis: a. Corporate focus on capacity to pay and corporate governance structure analysis of biz and operating risks b. ABS: i. No biz or operating risks with ABS. Emphasis on collateral quality capacity to generate cash flow to meet repayment obligations of each tranche under default and delinquency scenarios ii. Efficiency and Quality of servicer ABS servicer plays important role collecting cash flow from collateral pool and redistributing to tranches c. Municipal Securities i. Tax-backed bonds similar as analyse municipalitys willingness to pay and capacity to repay analyse industry, employment, real estate valuation as repayment from fees and taxes ii. Revenue bonds same as CFO of corporate. As cash flow from projects, focus on (1) projects capacity to generate revenue while controlling cost and (2) impact of trends in regional economy on cash flow. iii. Difference is rate covenants and priority-of-revenue claims clause unique to trust indenture of municipal revenue bonds require additional analysis d. Sovereign Debt i. Credit risk similar to credit risk analysis of corporate. ii. Capacity to pay = Economic risk of sovereign credits. iii. Character of Corporate Management = Political Risk of sovereign debt.

VALUING BONDS WITH EMBEDDED OPTIONS 1. Relative Value Analysis a. Comparing spread on bond to required spread (spread on comparable securities) and determine if bond over/undervalued relative to benchmark. b. Undervalued (cheap): spreads larger than required c. Overvalued (rich): spreads smaller than required d. Properly valued (fairly): spreads equal to required 2. Binomial Model a. Single factor I/R model which, at assumed volatility level, suggest I/R have equal probability of taking one of two values in next period. b. I/R Tree: set of paths that I/R may follow over time. c. Binomial I/R Tree: set of possible I/R paths used to value bonds with binomial model d. I/R at each node are 1-period forward rates corresponding to nodal period.

e. Eg: 7% annual coupon bond with 2 years to maturity.

3. Constructing I/R tree: a. Generate arbitrage-free values for on-the-run issues of benchmark security value of issues produced by tree must equal market price which excludes arbitrage opps. Without this requirement, cannot price call and puts. b. Step 1: Use yield on current 1 year on-the-run US treasury security issue for i0 c. Step 2: Assume I/R volatility () d. Calculate i1,L with i1,U = i1,L*e2 using coupon rate and market value of 2 year on-the-run issue obtain value of on-the-run issue. e. If model value higher than market price, increase i1,L guess. Repeat until obtain equal value. 4. Valuing Option-Free Bond a. Value of bond at given node is average of PV of two possible values from next period. b. Discount rate is forward rate associated with node. 5. Spread Measures a. Nominal Spread = Bonds YTM Yield on comparable-maturity treasury benchmark security i. Problem: use single I/R to discount each cash flow that makes up bond. If yield curve not flat, should discount each cash flow at spot rate for that maturity. b. Zero-volatility Spread (Z-Spread)

i. Spread when added to each spot rate on yield curve, makes PV of bonds cash flow equal to bonds market price. ii. Assumes zero I/R volatility Not appropriate for bonds with embedded option if volatile as it includes cost of option. iii. Approx. equal to nominal spread. Different if (1) yield curve not flat (2) for securities repaying principal over time (MBS) (3) long maturities. c. Option-adjusted Spread (OAS) = Z-Spread Option Cost i. Spread on bond with embedded option after option cost removed. ii. Calculated using binomial I/R model

6. Benchmark I/R a. Interpretation of spread depends on benchmark used b. Spreads measures compensation for credit risk relative to benchmark, liquidity risk relative to benchmark and option risk c. Without option cost, OAS measure only credit and liquidity risk 7. Benchmark Types: a. Treasury Securities: i. Nominal and Z-Spread reflect: (1) credit and liquidity risk relative to Treasuries, (2) Option Risk ii. OAS: credit and liquidity risk relative to Treasuries b. Specific sector of bond market with credit rating higher than issue being valued i. Nominal and Z-Spread: (1) credit and liquidity risk relative to bond sector, (2) Option Risk ii. OAS: credit and liquidity risk relative to bond sector c. Specific issuer i. Nominal and Z-Spread: (1) Liquidity risk relative to issuers other securities and (2) Option Risk. No credit risk as using issuers yield/spot curve. ii. OAS: liquidity risk relative to issuers other securities 8. Backward Induction Valuation a. Process of valuing bond using binomial I/R tree b. Backward: Find current value of bond with N compounding periods by computing bonds possible values at period N and working backwards to Node 0. 9. Callable bond value a. Value used at node corresponding to call data and beyond must be lesser of: i. Price at which issuer call bond at that date (call rule) or

ii. Computed value if bond not called. b. Possible for call schedule with different call price at different points in time. c. Eg. (2e): Callable in one year at 100.

10. Relation of option bond, option-free bond and options

11. Impact of volatility a. As I/R volatility increase, value of call option increases (to issuer) b. As volatility up, upside price in binominal tree will not rise above call price (capped) but downside price will fall callable bond value fall but arbitrage-free value of noncallable unaffected. 12. OAS calculation a. To produce arbitrage-free value for callable bond, I/R tree must be adjusted for option using OAS. b. Assume option exercised when in-the-money. c. Eg. (8c). If bond market price is $101.531, selling at discount to model value. Verify that 50bps added to each 1 year rate will give market price:

13. Relative OAS Valuation

14. Effective Duration and Convexity a. Modified Duration measures bonds price sensitivity to I/R changes, assuming cash flows do not change as I/R change b. Convexity used to improve price change estimate from modified duration c. Both not useful for bonds with options as cash flows may change if option exercised instead use effective duration and convexity. d. Factors effecting effective duration and convexity: i. I/R volatility assumption ii. Call and/or put rule iii. Benchmark I/R used to generate I/R tree

e. f. g. h. i.

Step 1: Calculate OAS for issue using binomial model. Step 2: Impose small // shift on yield curve by amount +y Step 3: Build new I/R tree using new yield curve Step 4: Add OAS to each 1 year rate to get modified tree assume OAS dont change when I/R change Computer BV+y with modified tree and repeat for // rate shift of -y

15. Value of Putable Bond a. Gives holder right to sell(put) bond to issuer at predetermined price prior to bond maturity. b. Value of put option increase as volatility increase investors willing to pya more for bond that gives them right to sell at price > market value. 16. Convertible Bond a. Owner has right to convert bond into fixed number of common shares of issuer b. CB call option different from option in callable bond: i. CB holder owns option, not issuer ii. CB holder has right to buy shares with bond that changes in value, not with cash at fixed exercise price. c. Conversion ratio no. of common shares for which CB can be exchanged. i. Eg. Issue at par with ratio of 10 means can convert one $1000 bond into 10 shares of common stock. Conversion price is $1000/10 shares = $100

d.

e.

f. g. h.

i.

ii. If bond not issued at par, conversion price is issue price/conversion ratio. Almost all CB are callable, which gives issuer ability to force conversion if bond worth more than call price and issuer call, optimal for holder to convert into shares rather than sell back at lower call price. Some CB are putable. i. Hard put : require issuer to redeem bond with cash ii. Soft put: payment choice of cash, common stock and/or subordinated notes Conversion Value = market price of stock x conversion ratio value of common stock into which bond can be converted. Straight (investment) value is value of CB if not convertible PV of bonds cash flows discounted at required return on comparable option-free issue Min value of CB must be greater of conversion or straight value, else arbitrage opp possible. i. Eg. if CB< conversion value, could be purchased, immediately converted into common stock and stock sold for more than bond cost. Market conversion (conversion parity) price price that CB holder would pay for stock if bought bond and immediately converted it.

market conversion premium per share = market conversion price market price

j.

Premium payback period i. Coupon income from CB > dividend income if stock owned directly ii. On per-share basis, tends to offset market conversion premium iii. PPP is time to recoup per-share premium or breakeven time

k. CB investors downside risk limited by bonds underlying straight value as CB price will not fall below this value regardless of what happens to price of issuers common stock. i. Downside risk measured by premium over straight value

17. Valuing Convertible Bonds using Option-based Valuation a. Investing in noncallable/nonputable CB is equivalent to buying (1) option-free bond or (2) call option on amount of common stock equal to conversion ratio. i. Noncallable CB value = straight value + value of call option on stock. ii. Black-Scholes-Merton can be used to establish call option value. Note that stock price volatility is positively related to call option value if price volatility up, convertible value increases. b. Most CB are callable.

i. Callable CB value = Straight Value of Bond + Value of Call on Stock Value of Call on Bond ii. Call is function of I/R volatility and economic conditions that can trigger call. BSM cannot be used in this case. iii. Callable and Putable CB value = Straight Value of Bond + Value of Call on Stock Value of Call on Bond + Value of Put on Bond iv. Again, BSM not appropriate to value options that depend on future I/R c. Impact of volatility changes on callable CB: i. Increase in stock price volatility increase in value of call on stock increase value of callable CB ii. Increase in I/R volatility increase in value of call on bond reduce value of callable CB 18. Risk-Return of CB vs Underlying a. Buying CB in lieu of stocks limits downside risk i. Price floor set by straight bond value causes downside protection ii. Cost of downside protection is reduced upside potential due to conversion premium iii. Still, CB investors must still look at risks (credit, call, I/R, liquidity) b. Comparing with underlying stock i. When stock price falls, returns on CB> stock as CB has price floor equal to straight bond value. ii. When stock price rise, bond underperform due to conversion premium. iii. When stock price stable, return on CB may exceed stock due to coupon payments received from bond (assume no change in I/R or yield or credit risk of issuer) c. Fixed-Income equivalent (busted convertible): Common stock price so slow that has little/no effect on CB market price trade like straight bond. d. Common stock equivalent: Common stock price high enough that convertible price behave like equity security. e. Hybrid security: most common. Characteristics of equity and fixed-income security.

MORTGAGE-BACKED SECTOR 1. Mortgage loan collateralised with specific piece of real property (residential/commercial) a. Borrower make series of mortgage payments of loan life b. Lender has right to foreclose or lay claim against real estate if default c. Mortgage (contract) rate - I/R on loan d. Net interest (Received by Lender) = Mortgage Rate Service Fee e. Prepayments Payments in excess of required monthly amount. f. Curtailments Prepayments for less than outstanding principal balance. g. Prepayment Penalties Aimed at reducing prepayment risk when I/R decline. Usually not for US residential mortgages. 2. Conventional Mortgage a. Most common residential mortgage

b. Loan based on borrower creditworthiness and collateralised by residential real estate used to purchase c. If borrower credit quality questionable/lack sufficient down payment, lender may require mortgage insurance to guarantee loan i. From government agencies and private insurers ii. Cost borne by borrower raises I/R on loan 3. Key Factors of Mortgage-Backed Securities (MBS) a. Principal payment increases as time passes (Scheduled Amortisation) b. Interest amount decreases as time passes c. Servicing fee/spread (for admin activities) declines as time passes d. Prepayment Risk ability of borrower to prepay. Prepayment and curtailments reduce interest to lender and causes principal to be repaid sooner. 4. Mortgage Passthrough Security a. A claim against pool of mortgages. i. Investors receive monthly cash flows generated by underlying pool, less servicing and guarantee/insurance fees. ii. Fees result in passthrough rates < average coupon rate of underlying iii. Timing of cash generation and receival doesnt coincide due to delay in service provider receiving mortgage payments and cash passing through to holders. iv. Key characteristic is sig prepayment risk as collateral (mortgages) can be repaid. b. Securitised mortgage any mortgage included in the pool c. Weighted average mortgage weighted average of all mortgage in pool, each weighted by relative outstanding mortgage balance to value of entire pool. d. Weighted average coupon weighted average of mortgage rates in pool e. Securitisation: as passthrough securities can be traded in secondary market, convert illiquid mortgages into liquid securities f. U.S. major agency passthrough securities: i. Ginnie Mae Issued by Govt National Mortgage Association. No credit risk as guarantee backed by full faith and credit of US govt ii. Freddie Mac Issued by Federal Home Loan Mortgage Corporation. Govtsponsored enterprise. Very high credit quality. iii. Fannie Mae Issued by Federal National Mortgage Association. Govt-sponsored enterprise. Very high credit quality. 5. Benchmarks for Prepayment Rates a. Conditional Prepayment Rate (CPR) i. Annual rate at which mortgage pool balance assumed to be prepaid during life of pool. ii. Single Monthly Mortality Rate (SMM) is monthly prepayment rate. Eg. 10% SMM implies 10% of pools beg-of-month balance, less scheduled payments, will be prepaid during month. b. Public Securities Association (PSA)

i. Assumes monthly prepayment rate increases as pool ages or becomes seasoned ii. Expressed as monthly series of CPRs iii. Standard benchmark is 100% which assumes for 30 year mortgages: 1. CPR = 0.2% for first month after origination, increasing by 0.2% per month up to 30 months. Eg. CPR in mth 14 = 2.8% (14x0.2%) 2. CPR = 6% for 30-60 months 3. CPR = (x/100) PAS x single month CPR c. Calculating Prepayment Amount

6. Prepayment Factors a. Prevailing mortgage rates i. Spread between current and original rate. If homeowner holding higher I/R mortgage and current rates fall, refinance incentive large. ii. Path of mortgage rates from point formed will current level. Refinancing burnout: if I/R fell once, most would refinance so if I/R fall again, less likely to act. b. Housing turnover i. Increase as rates fall and housing more affordable increase refinance and prepayments. ii. Increase when economic growth higher personal income up and people move to pursue career opps. c. Underlying mortgages i. Seasoning (Age of Loan) Prepayment low for new mortgage but increase as loan seasons. ii. Property location prepayments tend to be faster in some parts of country and slow in others. 7. Prepayment Risks a. Contraction Risk decrease security avg life due to falling I/R and higher prepayment rates. i. When I/R decline, MBS exhibit negative convexity due to embedded call option granting borrower right to prepay restricts upside price potential of passthrough securities as investors receive principal sooner (like callable bond) ii. Reinvestment rate risk earlier principal receipt means investors need to reinvest at relatively lower rates. b. Extension Risk i. When I/R rise, bond price fall. ii. With passthroughs, accompanying decrease in prepayments compounds price decline as timing of cash flows extended further (increase security avg life). iii. Undesirable for ST investors who prefer to recapture principal asap and reinvest at higher rates. c. Average Life vs Maturity i. Due to contraction and extension risk, maturity of mortgage passthrough security unlikely to equal true life. ii. Instead, use average life (weighted average time until scheduled principal payments and expected prepayments received).

8. Collateralised Mortgage Obligation (CMO) a. Securities issued against passthrough securities for which cash flows reallocated to different bond classes (tranches), each having different claim. b. Each CMO tranche rep different mixture of contraction and extension risk. c. CMO can more closely match to unique asset/liability needs of investors & managers d. Redistribution does not eliminate risk, merely repackage and apportion to different class of bondholders Still, enhances investment value of mortgage pool. 9. Sequential Pay CMO a. Each class of bonds retired sequentially. b. Principal payments directed to first (short) tranche until completely amortized before being accrued to second tranche. c. Short tranche which matures first offers more protection against extension risk. d. Second tranche offers more protection against contraction risk. e. Principal Pay Down Window time period between first and last principal payments on CMO tranche. Time at which tranche falls to zero. f. Z/Accrual tranche last tranche to receive principal also does not receive current interest until other tranches paid off. Diverted interest added to outstanding principal balance. Securities that rep claim called Z/Accrual bonds. 10. Planned Amortisation Class (PAC) CMO a. Most common b. Tranche amortised based on sinking fund schedule established within range of prepayment speeds (initial PAC collar) c. Two principal repayment schedules: lower and upper rate of initial PAC collar. d. Bondholders guaranteed principal payment equal to lesser amount prescribed by both schedules gives highly predictable life. e. PAC window time period of which principal expected to be paid. Narrower window = tranche resemble corporate bond with bullet payment.

11. Support Tranche a. Included to provide prepayment protection for PAC tranche b. When prepayment speed of collateral stay within initial collar, absorbs excess or provide principal when needed so principal received as scheduled. c. If prepayment speed outside initial collar, speeds vary but stay within collar, PAC tranche principal amortisation schedule not necessarily met.

d. Extent of prepayment risk protection provided by support tranche increase as par value increase relative to associated PAC tranche. e. Inverse relation between prepayment risk of PAC tranche and that associated with support tranche certainty of PAC bond cash flow comes at expense of increased risk to support tranche. f. When prepayments slower than planned, average life of support tranche extended as PAC tranche have priority claim against cash flow, deferring principal payments to support tranche. (higher extension risk) g. When prepayments faster than expected, support tranche must absorb excess to maintain repayment schedule for PAC, causing its average life to contract. (higher contraction risk) If excess continue, support tranche paid off and principal goes to PAC holders broken/busted PAC. h. CMO PAC with Support Tranche: i. PAC I Tranche PAC structure of support tranche with PAC principal repayment schedule ii. PAC II Tranche Support tranche for PAC I tranche that has PAC schedule of principal repayments. Higher prepayment risk (and avg life variability) than PAC I tranche but more prepayment protection (and avg life variability) than support tranches without schedules for principal repayment. 12. Stripped Mortgage-Backed Securities a. Principal and interest not allocated on pro rata basis price/yield relationship that is different from underlying passthrough. b. Principal-Only (PO) strips i. Receive only principal payment portion of each mortgage payment. ii. Sold at considerable discount to par. iii. Cash flow stream starts out small and increases with time as principal component payment grows. iv. Entire par value of PO ultimately paid to investor. Only whether prepayment rates will cause sooner or later payment. v. Performance extremely sensitive to prepayment rates: higher rates (when mortgage rates decline) faster-than-expected return of principal higher return (PO price increase). vi. Exhibit some negative convexity at low rates. c. Interest-Only (IO) strips i. Receive only interest component of each payment. ii. Cash flow starts out big and gets smaller shorter effective live than POs. iii. Major risk is value of cash flow over life of pool may be less than expected and less than originally invested depend on market rates. iv. Positively related to mortgage rates at low current rates: rates decline below average pool rate prepayment increase, principal falls interest payments fall (IO price fall). d. Both IO and PO exhibit greater price volatility than passthrough because their returns negatively correlated but combined price volatility of two strips equal volatility of passthrough.

13. Agency vs Nonagency MBS a. Nonagency MBS issued by private entities i. Backed by pool of 1-4 single-family residential first-lien mortgages (main) ii. Backed by second mortgage loans, manufactured housing loans, variety of commercial real estate loans iii. Backed by nonconforming mortgage loans loans fail to meet agencys standards. iv. Non CMOs formed with whole (unsecuritised) loans v. Affected by mortgage default rates require credit enhancement. b. Agency MBS must conform to underwriting standards of issuing/guaranteeing agency, such as max loan-to-value ratio, payment-to-income ratio, loan amount. i. CMOs formed by splitting up pool of passthrough securities ii. Backed by pseudo-govt guarantee so relatively more certain cash flow risk and expected return lower than nonagency. 14. Commercial MBS backed by income-producing real estate. a. Apartments, warehouses, shopping centres, office, health care facilities, senior housing, hotel/resort properties b. Most Common: Originated by conduit organisations who negotiate and close the loans that are incorporated into CMBS. c. Others: liquidating trusts, multi-property single-borrower programs 15. Credit Risk Analysis of Nonagency CMBS and RMBS a. Biggest difference is obligation of underlying borrower i. Residential repaid by homeowner while CMBS repaid by real etate investors who rely on tenants and customers to provide cash flow to repay loan. ii. CMBS structured as nonrecourse loan (lender can only look to collateral as means to repay delinquent loan if cash flow insufficient) while RMBS can go back to borrower personally. 16. Hence, CMBS analysis focus on property (not borrower) credit risk. a. Debt-to-service coverage = net operating income / debt service i. Amount of cash flow from commercial property available to make debt service payments.

ii. NOI is after reduction for real estate tax but before relevant income taxc. iii. Ratio between 1-2: provides comfort to lender and investor as increase iv. Ratio < 1: borrower not capable of making debt payments and likely to default. b. Loan-to-value = current mortgage amount / current appraised value i. Compared loan amount on property to current fair market/appraisal value. ii. Lower ratio, more comfortable lender is to make loan. iii. Determines amount of collateral available, above loan amount, to provide cushion to lender should property be foreclosed on and sold. 17. CMBS structure and call protection a. Basic CMBS structure created to meet risk and return needs of CMBS investor. b. Rating organisations (S&P, Moodys) assess credit risk of each issue and determine credit rating highest credit quality tranche repaid first. 18. Call protection in two ways: a. Loan-level call protection provided by structure of individual mortgage. Any prepayment penalties received are distributed to investors in manner determined by CMBS structure. i. Prepayment lock-put: for specific period (2-5 years), borrower prohibited from prepaying mortgage loan. ii. Defeasance: if borrower insist on making payments, loan proceeds received by servicer and invested in US Treasury securities create cash collateral against loan. Upon completion of defeasance period, US treasuries liquidated and proceeds used to repay mortgage. Treasuries provide higher quality collateral than underlying real estate, so defeased loans increase CMBS credit quality. iii. Prepayment penalty point: penalty fee charged if borrower prepays loans. Much higher in eraly years then steps down until disappears. Eg. 5-4-3-2-1 (5% in 1st year) iv. Yield Maintenance Charge: borrower charged amount of interest lost by lender if loan prepaid. The make whole charge makes lenders indifferent to prepayment. b. Call protection provided by CMBS structure i. Pools segregated into tranches with specific repayment sequence. ii. Tranche with higher priority for prepayment/collateral position have higher credit rating than lower priority tranche.

ASSET-BACKED SECURITIES 1. Securitisation Transaction a. Seller originates loans and sells to trust (SPV) b. Issuer/Trust SPV that buys loans from seller and issues ABS to investors c. Servicer services loans. d. Waterfall i. Flow of funds structure ii. Principal and interest payments on original loans paid by customers to servicer.

iii. Cash flow allocated to pay servicing fees to servicer, and principal and interest to investors in ABS tranches according to priority rules set out in prospectus. e. ABS most commonly backed by automobile loans, credit card receivables, home equity loans, manufactured housing loans, student loans, Small Business Admin (SBA) loans, corporate loans, corporate bonds, emerging market bonds, structured financial products. 2. Prepayment vs Credit Tranching a. Prepayment/Time tranching ABS structured to distribute the prepayment risk b. Credit Tranching i. ABS has credit risk in addition to prepayment risk. Credit enhancement reduces credit risk ii. Most common is senior-subordinated structured where subordinated bonds absorb all losses up to par value, after which additional losses absorbed by senior bonds Credit risk shifted from senior to subordinated bonds.

3. Amortising Assets a. Loans for which borrower makes periodic scheduled payments including principal and interest b. Interest subtracted from total payment and balance applied toward principal, reducing outstanding loan. c. Amounts in excess of scheduled payment (prepayments) applied to further reduction of principal. d. Example: Residential mortgage. 4. Non-amortising Assets a. Loans that dont have scheduled payment amount. Instead, min payment (applied against accrued interest) is required. b. If min payment exceeds accrued interest, excess applied toward reducing outstanding principal. If payment falls short of accrued interest, outstanding loan balance increased by shortfall. c. Example: revolving credit card loan. 5. ABS structure a. For amortising assets, once securitised, composition of loans in pool doesnt change. Loans disappear as paid off or default, but no new loans added to pool for replacement.

b.

c.

d. e.

Principal payments and repayments on remaining loan distributed according to structure rules. For non-amortising assets, composition of loans in pool changes. During lockout period (first 18 months), principal payments and prepayments not distributed to bondholders. Instead, invested in new loans to replace amounts paid off (revolving structure) Bonds issued in revolving structure can be retired early under certain conditions by required cash flows to be directed to reduction of principal rather than new loan purchase call provision triggered by events (eg. collateral poor performance) For non-amortising collateral, due to ABS call provision, while loans no prepayment risk, securities backed by collateral which may have prepayment (call) risk Revolving possible for amortising assets too. Principal and prepayments during lockout period used to acquire additional collateral.

6. Credit Enhancements a. Accompany all ABS b. Level of enhancement directly proportional to level of rating desired by issuer. c. Rating agencies determine exact amount of enhancement necessary for issue to hold specific rating. 7. External a. Financial guarantees from third parties that support performance of bond. Used to supplement other forms of credit enhancements. b. Third-party guarantees impose limit on guarantees liability for losses at specified level protect against losses before internal enhancements used. c. Examples: i. Corporate guarantees sponsor (securities seller) agrees to guarantee portion of offer ii. Letter of credit bank letter of credit provides guarantee against loss up to certain level iii. Bond Insurance protection against non-performance d. Problem: weak link philosophy. Credit quality of issue cannot be higher than thirdparty guarantor. If guarantor downgraded, issue may also be downgraded even if no decline in credit quality of underlying collateral 8. Internal a. Reserve funds i. Cash reserve funds cash deposits that come from issuance proceeds. Excess cash provides for establishment of reserve account to pay for future loss ii. Excess servicing spread funds funds in the form of excess spread or cash after paying for servicing and other expenses. Can be used to fund credit losses on collateral. However, if defaults > initial projected, effectiveness diminished. Need to examine default-related assumptions. b. Overcollateralisation i. When ABS issued with face value less than value of underlying collateral ii. Eg. if liability structure is $100 mil and collateral value is $105 million, overcollateralised by $5 mil and used to absorb losses. c. Senior/Subordinated Structure

i. Contains at least 2 tranche (senior and junior/subordinated). ii. Subordinated absorbs first losses up to their limits. Level of protection for senior tranches increase with % of subordinated bonds in structure. d. Shifting interest mechanism i. Address change in level of credit protection provided by junior tranche as prepayments occur. ii. Reduces credit risk of senior tranche but trade-off is greater prepayment risk. iii. Subordinate interest - % share of junior/subordinate tranches to total outstanding balance. iv. Principal on junior tranche reduced by prepayment subordinate interest decline level of protection for senior tranche reduced (ie. Subordinate interest shifts) v. To maintain subordinate interest at desirable level, prepayments allocated among senior tranche at relatively high proportion in early years. vi. Bond prospectus contain schedule for shifting interest % required to calculate senior prepayment %. But schedule not fixed, as issues trustees may change if credit loss cause credit risk of senior tranche to increase. vii. While shifting interest mechanism can effectively maintain desired level of credit risk protection, comes at expense of increased contraction risk for senior tranches. viii. Common used for real-estate related ABS and non-agency MBS. 9. Home Equity Loans (HEL) a. Loan backed by residential property. b. Used to be second lien on property with existing first lien. c. Now, first lien on property owned by borrower that has marginal credit history or loan that does not meet agency requirements for qualified loan. d. Also commonly used to consolidate consumer debt. e. Closed-end HEL i. Structured like standard fixed-rate, fully amortising mortgage one-time lump sum loan with fixed maturity and payment structure where loan fully amortised at maturity. ii. ABS issued on pool of closed-end HELs similar to MBS in absence of tranching, each holder receive proportional share of principal and interest paid on underlying. Hence, prepayment model employed to estimate cash flows to HEL pool. 10. Prepayments for HEL a. Pattern differs from MBS because of difference in borrower credit traits. higher prepayments at lower rates more likely for higher credit quality borrowers. b. Base case prepayment assumption: made regarding initial speed of prepayments and time until issue become seasoned (prepayments stabilise). c. Prospectus prepayment curve (PPC): benchmark speed stated in prospectus and used similar to PSA curves. If speed of seasoning for issue is faster/slower than stated, analyst employ multiplication factor to adjust PPC to reflect actual behaviour. Unlike PSA, issuerspecific benchmark (not generic).

d. Conditional prepayment rate (CPR): speed of prepayment measured using PPC benchmark. 11. HEL Payment Structure a. HEL Floaters: HEL-backed securities collateralised with variable rate HELs i. Individual variable rate HELs commonly use 6-mth LIBOR as reference rate ii. HEL floaters use 1-mth LIBOR as reference rate iii. Depends on investor preference. iv. Mismatch between reference rates may result in cash shortfalls over time. b. Due to shortfall and periodic & lifetime caps on underlying variable rate loans, HEL floaters must have coupon rate caps. i. HEL Floaters have variable effective periodic and lifetime caps. Unlike most floating-rate securities which have fixed caps over term of security. ii. Available funds cap: effective cap. Determined on basis of net coupon-generated funds, less all applicable fees. c. Non-accelerating senior tranches (NAS) i. Receives principal payments on basis of predetermined schedule. ii. Usually, NAS tranche receive no prepayments in early years (its share paid to other senior tranche), reducing contraction risk. In latter years, NAS tranche receive high % of prepayments, reducing extension risk. d. PAC tranche i. Prepayments to PACs stable if prepayments fall within specified PAC collar. 12. Manufactured Housing-backed Securities a. Backed by loans for manufactured homes (eg. mobile homes) b. Similar to standard mortgage loans as they fully amortize over loan life. c. Ginnie Mae and private orgs issue them. 13. Cash Flow and Prepayments a. Cash flow includes interest, scheduled principal payments, prepayments. b. Prepayments measured in terms of conditional prepayment rate. Usually less significant compared to MBS and HEL as underlying loans not as sensitive to refinancing: i. Loan balance small, reducing extent of savings resulting from refinancing ii. Depreciation of mobile homes in earlier years greater than reduction of loan principal, resulting in asset value < outstanding loan amount. iii. Borrowers likely low credit ratings, difficult to refinance. 14. Payment Structure a. Similar to nonagency MBS and HEL. b. Each issue divided into difference classes, each with different claim against cash flow components of underlying collateral pool. 15. Auto Loan ABS a. Backed by loans for automobiles. b. Maturities from 36-72 months. c. Issuers include financial subsidiaries of auto makers, commercial banks, credit unions, S&Ls, finance coys, small financial institutions.

d. Cash flow components include schedule monthly interest and principal payments and prepayments. i. Prepay if cars sold, traded in or repossessed. ii. Prepay if car stolen, wrecked and loan paid off from insurance proceeds. iii. Borrower may use excess cash to reduce or pay off loan balance. e. Refinancing not major factor to prepayments Sig reduce prepayment risk i. Loan balance small, reducing extent of savings from refinancing, esp cuz usedcar refinancing rates higher than new car rates. ii. Automobile value depreciate faster than loan balance in early years, resulting in asset value < outstanding loan amount, esp if loan originally done at belowmarket rates due to sales promotions. 16. Absolute Prepayment Speed (ABS) a. Measure of prepayments associated with securities backed by auto loans b. Monthly prepayment expressed as % of initial collateral value. c. Similar to CPR. d. Single Monthly Mortality Rate (SMM)

17. Student Loan-backed Securities (SLABS) a. Mainly by lending institutions under US Govt Federal Family Education Loan Program (FFELP). b. US govt guarantee loans made by private lenders to students. If FFELP loan default, US govt guarantees up to 98% of loan principal and accrued interest on condition that loan serviced properly. c. Alternative loans: securitised student loans not part of FFELP d. Cash Flows of SLABS occur during: i. Deferment period: borrower make no payments and loan accrues no interest ii. Grace period: borrower makes no payments but interest accrue iii. Loan repayment period: borrower makes principal and interest payments based on reference rate plus margin e. Prepayments may occur due to defaults (inflow from Govt guarantee process) or loan consolidation 18. Small Business Administration (SBA) Loan-backed Securities a. SBA is US govt agency whose guarantees backed by full faith and credit of US govt it guarantees loans made by private lenders to borrowers who meet specified guidelines private lenders must be approved by SBA for loans to be eligible b. Pooled SBA loans must have similar terms and features. i. Variable-rate loans, based on prime rate, and reset either monthly or quarterly.

ii. Monthly payment for individual variable-rate loan includes interest and repayment-of-principal. iii. Level amortising loan payments calculated based on reference rate at beginning of each reset period. c. SBA-backed security investor receives: i. Interest based on coupon rate set at beg of reset period ii. Principal repayment based on amortisation schedule developed at time of loan origination iii. Prepayments received by lender applied to outstanding loan 19. Credit Card Receivable-Backed Securities a. Backed by pools of receivables owed to banks, retailers, travel and entertainment companies, and other credit card issuers. b. Use structure enabling issuer to sell more than one series from same pool of receivables more receivables added each time new series issued bal never reduced to zero c. Cash flow include finance charges, annual fees, principal repayments. d. Have periodic payment schedules but as balances revolving, principal not amortised interest on ABS paid periodically but no principal paid to holders during lockout period (18mths 10 yrs) i. If credit card holders make principal payments during lockout, payments used to purchase add underlying assets/receivables keeps overall value of pool constant. ii. Once lockout ends (principal amortisation period), principal payments passed on to security holders. e. Distribution of payments: i. Passthrough structure: principal payments received from credit card holders distributed pro rata to investors ii. Controlled-amortisation structure: principal window similar to PAC bond. ABS designed with low principal payment in schedule. If shortfall, investor receives lower of principal payment or pro rata of principal repayment. iii. Bullet-payment structure: investors receive total principal amount in single payment but uncertain nature of principal payments means no guarantee total amount available when bullet payment due use soft bullet structure iv. Soft bullet structure: ABS trustees place monthly principal payments in interestbearing account to fund bullet payment. Accumulation period begins few months prior to scheduled bullet payment. f. Performance of receivables portfolio (table) i. Gross portfolio yield = finance charges and fees collected as % of outstanding receivables ii. Charge offs = % of uncollectible accounts charged off

g. Early amortisation trigger i. Protect investor against declines in credit quality of underlying receivables ii. Most common is when 3-mth average excess spread earned on receivables declines to zero iii. Even if no principal repayment schedule for credit card borrowers, trigger provision creates potential for contraction risk in receivables-backed structure 20. Collateralised Debt obligations a. ABS collateralised by pool of debt obligations

b. Structure: i. One or more senior tranche: 70-80% of entire deal. Assigned floating-rate payment to attract investors looking for floating-rate investment. ii. Several levels of mezzanine tranche: assigned fixed-coupon payment. iii. Equity (subordinate) tranche to provide prepayment and credit protection to other tranches c. Collateral pool contains mix of floating and fixed rate debt instruments. However, payments to majority of tranche holders based on floating rate potential cash flow mismatch. i. I/R swaps used to control I/R risk due to mismatch. ii. Convert fixed-rate interest receipts into floating-rate payments. iii. Inclusion of swap almost always mandated by rating agencies. 21. Cash Flow CDO a. Objective for portfolio manager to generate sufficient cash flow to repay senior and mezzanine tranches.

b. Phases: i. Ramp up phase: 1-2 months. Portfolio Manager puts together portfolio financed with help of different tranche sales to investors ii. Reinvestment phase: after portfolio assembled, Asset Manager monitors performance and reinvestments prepayments and cash flows from calls and loan default recoveries. iii. Pay down phase: 3-5 yrs. Principal payments made to junior and senior tranche holders. c. Portfolio income first used to pay admin and management fees, then interest on senior tranche. i. If coverage tests (par value, interest coverage) met, interest paid to mezzanine tranche, and remaining cash flow to equity tranche. ii. If coverage not met, cash flow retire senior tranche principal until coverage tests met. d. During reinvestment period, portfolio principal proceeds reinvested in new securities if coverage tests met. After period, principal proceeds used first to pay down senior tranche, then mezzanine tranche and finally equity tranche. e. Portfolio manager actively manages portfolio but does not try to generate trading profits to meet cash flow obligations of tranche. Instead, make interest and principal repayments suff to meet cash flow obligations and rebalance as necessary. 22. Market Value CDO a. Manager actively manage portfolio and sell asset to generate cash flows to meet CDO tranche obligations. b. More flexibility than manager of cash flow CDO 23. Synthetic CDO a. Bondholders take economic risks of underlying assets but not legal ownership. b. Link certain contingent payments to reference asset (eg. bond index) c. Debt obligations only issued to fund junior section but none issued to fund senior section. i. Junior absorb losses up to certain level before senior section forced to absorb. ii. Proceeds from junior invested by portfolio manager in high-quality debt securities d. Holders sell credit default swap where seller receive premium in return for obligation to pay buyer specific amount if credit event occur on reference asset. i. If credit event, seller pay difference between par and fair market value of bond. ii. Usually carry AAA rating as deal structured so chance of losses exceeding amount very small. e. Junior bondholders receive income from high-quality debt securities in portfolio and insurance premium on swap. But also exposed to credit loss in reference asset similar to junior bondholders in cash CDO. f. Advantages of synthetic to cash for arbitrage CDO: i. Senior section dont need funding ii. Ramp-up period shorter iii. Cheaper to acquire exposure to reference asset through swap instead of buying asset directly

24. Motivations to create CDO a. Arbitrage-driven: Majority. Generate arbitrage return on spread between return on collateral and funding costs. b. Balance-sheet driven: remove assets and associated funding from balance sheet. i. Eg. bank use synthetic B/S CDO to remove credit risk of loan portfolio from B/S and reduce regulatory capital requirement. ii. Advantage is dont need to obtain borrower consent.

VALUING MBS AND ABS 1. Cash Flow Yield discount rate that makes price of MBS/ABS equal PV of its cash flow. a. Estimate future monthly cash flows b. Calculate monthly rate of return where PV of future cash flow = securitys current market price. c. Usually converted to bond-equiv basis for comparison to YTM: d. Challenge: i. MBS/ABS cash flows uncertain due to prepayment rates make prepayment assumption. ii. If not agency issue, also need assumption on default and recovery rates. e. Deficiencies when use cash flow yield as estimate of bonds expected return: i. Reinvestment Risk: Assume cash flows reinvested at cash flow yield prevailing when MBS/ABS priced. ii. Price Risk: Assume MBS/ABS held until last loan in pool paid off. If security sold prior to expected maturity, uncertainty introduced regarding terminal cash flows iii. Assume cash flows realised as expected. Likely violated for MBS/ABS than other fixed-income securities due to prepayment risk. 2. Nominal Spread difference between cash flow yield on MBS and YTM on Treasury security with maturity equal to MBS average life. a. Portion of nominal spread represents compensation to investor for exposure to prepayment risk b. Limitation: Dont know how much of nominal spread reflects significant prepayment risk associated with MBS. Esp true for support CMO tranches. 3. Zero Volatility (Z)Spread a. Spread added to each Treasury spot rate that will cause discounted value of cash flows for MBS/ABS to equal price, assuming security held till maturity. b. Z-Spread and Nominal Spread converge as MBS average life decrease. Difference between Z-Spread and Nominal Spread increase as slope of yield curve increase. c. Limitation: only consider one path of I/R the current Treasury spot rate curve. i. For bonds with embedded options sensitive to changes in I/R volatility (eg. MBS), should use option-adjusted spread (OAS) 4. Monte Carlo Simulation - Used to valuate MBS

a. Simulate I/R paths and cash flow using assumptions on benchmark rates, rate volatility, refinancing spreads and prepayment rates. Non-agency MBS need assumption on default and recovery rates. b. Calculate PV of cash flows along I/R paths c. Calculate theoretical value of MBS as average of PV along each path d. Calculate OAS as spread that makes theoretical value = market price e. Calculate option cost as Z-spread minus OAS. f. Modelling Risk: value derived very sensitivity to I/R volatility assumption and prepayment assumption g. As number of paths generated increased, resulting estimate is better. However, can maintain accuracy while reducing full number of sample paths through representative paths MBS theoretical value = weighted average of PV of each rep path, weighted by path weight. 5. Due to path dependence of MBS cash flows, Monte Carlo used instead of binomial model. a. Binomial model assume value of cash flow at given point in time independent of path that I/R followed up to that point decision to use call price or theoretical value at node is determined by assumed I/R at time decision made, not past I/R. b. But MBS cash flow depend on path that I/R follow, so cant use binomial model or other model with backward induction methodology. c. Sources of path dependency: i. Prepayment Burnout: Mortgage rates trend downward over period, prepayment rates increase at beginning of trend as homeowners refinance mortgage but slow as trend continues as refinance completed. Apply to passthrough security and CMO tranche. ii. Cash flows that CMO tranche receive in one month depend on outstanding principal balance of other tranche, which depends on prepayment history and I/R path. 6. OAS a. For Monte Carlo, it is the spread added to every spot rate along every I/R path. b. It is MBS spread after optionality of cash flows taken into account. $ difference between price and theoretical value as spread. c. Used to estimate cost of embedded prepayment option in MBS/ABS where option cost = Z-Spread minus OAS. d. It is the additional compensation for credit risk, liquidity risk, modelling risk (uncertainty in MBS value from assumption used in complicated Monte Carlo framework) relative to benchmark. e. Larger OAS is better: Wider OAS indicates larger risk-adjusted spread lower relative price.

7. Evaluate MBS using OAS a. Cheap securities undervalued on relative basis want to buy b. Rich securities overvalued on relative basis should sell c. For given Z-Spread and effective duration: i. Cheap securities have high OAS relative to required OAS and low option costs ii. Rich securities have low OAS relative to required OAS and high option costs d. On absolute valuation basis: i. Tranches trading at premium (discount) will see gains (losses) when assumed prepayment rate decreases ii. Increase (decrease) in assumed I/R volatility increase (decrease) the option cost and reduces (increases) MBS value iii. For both changes in prepayment rates and I/R volatility, gains (or losses) in value more pronounced for tranches with higher effective duration. 8. Spread Usage a. Nominal spread is spread between cash flow yield and yield on Treasury security with same maturity as MBS/ABS average life i. Spread at one point on Treasury yield curve ii. Never use for MBS and ABS because masks fact that portion of spread is compensation for accepting prepayment risk b. Z-Spread is spread over entire Treasury spot rate curve if MBS held until maturity i. Suitable to assess value of option-free bonds.

ii. Never use for bonds with prepayment options as dont reflect possibility that cash flows may change as I/R change c. OAS used to assess value of fixed-income securities with embedded options that make it possible for cash flows to change as I/R change i. If cash flow not I/R path dependent (eg. putable and callable bonds), OAS used with binomial model ii. If cash flow I/R path dependent (eg. ABS and MBS), OAS used with Monte Carlo. d. Appropriate valuation model for ABS depend on whether prepayment option available on underlying collateral and if option typically exercised: i. Z-Spread: Credit card receivable-backed ABS no prepayment option. Automobile loans have prepayment option but not typically exercised ii. OAS from Monte Carlo: ABS backed by high-quality HEL with prepayment option that frequently exercised when rates drop and borrowers refinance. Amounts of cash flows are path-dependent.

9. Duration measures sensitivity of securitys price to change in I/R a. Monte Carlo used to compute BV-y and BV+y b. Assumptions lead to different estimates between vendors/dealers:

i. Differences in y: if incremental change in I/R too large, effects of convexity contaminate effective duration estimates ii. Prepayment model differences iii. OAS differences: OAS is product of Monte Carlo. Difference in model inputs will affect measurements. iv. Differences in spread between 1-month rates and refinancing rates. Affects MBS computed value and subsequently different BV-y and BV+y values

10. I/R Risk with Effective Duration and Convexity a. I/R risk is risk that price of fixed income security will change as yields change. b. Effective duration is measure of I/R risk larger duration of security, greater I/R risk for small changes in yields. c. Convexity adjustment gives more precise estimate for large yield changes for given duration, greater convexity, lower I/R risk.

11. Cash Flow Duration a. Allows for cash flows to change as I/R change. b. Use static valuation procedure to determine BV-y and BV+y values. c. Computation:

d. Criticism: based on unrealistic assumption that new MBS prepayment rate constant over entire life for given shock to I/R. As Monte Carlo allow changing prepayment rates, effective duration better than cash flow duration for MBS. 12. Coupon Curve Duration a. Relationship between coupon rates and prices for similar MBS. b. Advantage: i. Easy to apply ii. Use market prices that presumably reflect market expectations c. Limitations: i. Only applicable to generic MBS ii. Not readily applicable for CMO structures and other mortgage-based derivatives 13. Empirical (Implied) Duration a. Use regression analysis of historical relationship between security prices (dependent variable) and yields (independent variable) b. Advantages: i. Requires few assumptions ii. Required parameters easy to estimate with regression analysis iii. Time series data for Treasury prices and yields readily available c. Disadvantages: i. Time series price data on mortgage securities difficult to obtain ii. Embedded options can distort results iii. Volatility od spreads over Treasuries can distort price reaction to I/R changes