-It is an indicator of perceived credit risk in the general
economy
-It reflects more accurately the risk in the banking system
compared to the swap spread
2. Z-Spread Implied Spot Curve yield + Spread necessary to discount
bond cash flow and derive market price
3. Price of a PCB = PNCB - PCB
Callable Bond PPB = PPB - PNPB
4. Convertible Convertible to Common Shares.
Bond Conversion Ratio = # SHS Convertible Bond can be trans-
ferred into
Conversion Price = Par (100) / Conversion Ratio (5)
5. Credit Analysis 1. Credit Ratings: Expected Loss = PD * LGD
Models 2. Structural Models: B/S approach, explains why default
occurs.
3. Reduced Form Models: Macro Fluctuations predict fu-
ture PDs. Does not explain why default occurs.
6. Securitized Debt 1. Collateral Pool
Credit Analysis 2. Servicer Quality
3. Structure (Overcollateralization, Traunching, Insur-
ance, Bank Guarantees)
Credit Spread on risky bond = (YTM Risky Bond) - (YTM
of Treasury)
7. Term Struc- 1. Credit Quality: Worse rating = wider spread over time
ture of Credit 2. Financial Conditions: Expansion = Narrow. Recession
Spreads = Widen.
3. Supply/Demand in Market: Less Liquid securities =
wider spreads.
4. Volatility in Markets: +Volatility = + Spreads
8.
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Local Expecta- Similar to unbiased expectations theory with one excep-
tions Theory tion. Local expectations theory preserves the risk-neu-
trality assumption only for short holding periods. Risk
premiums could exist in the long run.
9. Change in Price = - (Modified Duration) (Spread Change)
of a Bond
(IR+) = (PCB-), (PNCB-)
(IR-) = (PCB+), (PNCB++)
(IR+) = (PPB-), (PNPB- -)
10. Bond Convexity Option Free Bonds: Positive Convexity throughout
Callable Bonds: Negative Convexity when (IR-) and Pos-
itive Convexity when (IR+)
11. Effective Dura- ED = [(P-) + (P+)]/[2(P0)(Change Y)]
tion
Used for bonds with embedded options which make CFs
more uncertain
Calculates expected return / price decline for a bond
when IR+ 1%
12. Floating Rate Rate paid in arrears
Bond Issuer buys cap from bond holder to limit losses on inter-
est paid.
Investor buys floor from issuer to limit the low side of IRs.
13. Accrued Interest Interest incurred on a bond to a specific date before
coupon payout date.
Clean Price: Price Bond without AI
Dirty Price: Price Bond With AI
14. Callable Bonds PCB < PNCB usually due to reinvestment risk
American: Call can be called at any time.
European: Call can only be called at call date.
Call Option Exercised when IR Fall
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15. Putable Bond V(risky bond) = Vrf - Vput
Lower Yield than regular bond due to higher price.
If IR Rise, Bondholder can sell back to issuer. Avoiding IR
Risk, bondholder can take advantage of rising rates.
An extendible bond is equivalent to a putable bond with
put date at original maturity date.
16. Bond Character- 1. Longer Maturity = Higher Duration
istics Effect on 2. Lower Coupon = Higher Duration
Duration 3. Lower Mkt Yield (Higher bond price) = Higher Duration
4. Bond with Options = Lower Duration
17. Key Rate Dura- Price Sensitivity of a Bond to changes in rate at a specific
tion maturity date.
18. Macaulay Dura- Time weighted average term to maturity of cashflow of a
tion bond. Used for option free bonds.
= [SUM (PV * CF) * t]/PB
19. Effective Dura- Change in Price of Bond for a 100 bps change in IR.
tion
= MacDur / (1 + YTM)
ED (CB) < ED (NCB)
ED (PB) < ED(NCB)
ED (Zero Coupon) = Maturity Bond
ED Fixed Rate Bond < Maturity of Bond
20. Option Adjusted Z spread - option value
Spread
If Interest Rates are declining, issuer wants to call back
the bond.
(Volatility +) = (OAS CB -)
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21. Liquidity Premi- Lenders more willing to lend in short term than long term.
um Theory
Liquidity premium grows over time contributing to upward
sloping YC.
22. Bootstrapping FWD
SPOT
PAR
PAR
SPOT
FWD
23. Pure Expecta- The shape of the yield curve depends on investors' ex-
tions Theory pectations about future interest rates.
Implies that forward rate is an unbiased predictor of future
spot rates.
24. Preferred Habitat Investors prefer bonds of specific maturity to match A&L.
Theory
They will be willing to buy bonds of different maturities
only if they earn a higher expected return
Investors are likely to prefer short-term bonds over
longer-term bonds.
25. Forward Rates 2F3: 2Y implied Forward Rate 3 years from now.
Forward Rates are future expected spot rates. Derive
SPOT Rates from FWD rates.
26. Sources of Yield LT: Uncertainty from real economic growth & inflation
Volatility
ST: Uncertainty from Monetary Policy
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