Solution Manual for Fixed Income Analysis. 2E PDF

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Solutions Manual for

Fixed Income Analysis Second Edition

Frank J. Fabozzi, PhD, CFA

NOTE: This file includes solutions to the book’s end-of-chapter problems (Part II).

download instant at http://testbankinstant com CFA Institute is the premier association for investment professionals around the world, with over 85,000 members in 129 countries. Since 1963 the organization has developed and administered the renowned Chartered Financial AnalystProgram. With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investment community, and is the foremost authority on investment profession conduct and practice. Each book in the CFA Institute Investment Series is geared toward industry practitioners along with graduate-level finance students and covers the most important topics in the industry. The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series.

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Copyright  c 2004, 2007 by CFA Institute. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic formats. For more information about Wiley products, visit our Web site at www.wiley.com. ISBN-13 978-0-470-06919-6 ISBN-10 0-470-06919-8 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1

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CONTENTS PART I Learning Outcomes, Summary Overview, and Problems CHAPTER 1 Features of Debt Securities

3

Learning Outcomes Summary Overview Problems

3 3 5

CHAPTER 2 Risks Associated with Investing in Bonds Learning Outcomes Summary Overview Problems

CHAPTER 3 Overview of Bond Sectors and Instruments Learning Outcomes Summary Overview Problems

CHAPTER 4 Understanding Yield Spreads Learning Outcomes Summary Overview Problems

CHAPTER 5 Introduction to the Valuation of Debt Securities Learning Outcomes Summary Overview Problems

8 8 9 11

15 15 16 19

22 22 23 25

29 29 29 31

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Contents

CHAPTER 6 Yield Measures, Spot Rates, and Forward Rates Learning Outcomes Summary Overview Problems

CHAPTER 7 Introduction to the Measurement of Interest Rate Risk Learning Outcomes Summary Overview Problems

CHAPTER 8 Term Structure and Volatility of Interest Rates Learning Outcomes Summary Overview Problems

CHAPTER 9 Valuing Bonds with Embedded Options Learning Outcomes Summary Overview Problems

CHAPTER 10 Mortgage-Backed Sector of the Bond Market Learning Outcomes Summary Overview Problems

CHAPTER 11 Asset-Backed Sector of the Bond Market Learning Outcomes Summary Overview Problems

CHAPTER 12 Valuing Mortgage-Backed and Asset-Backed Securities Learning Outcomes Summary Overview Problems

33 33 34 35

41 41 42 44

49 49 49 52

55 55 55 58

63 63 63 65

73 73 73 78

83 83 83 86

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Contents

CHAPTER 13 Interest Rate Derivative Instruments Learning Outcomes Summary Overview Problems

CHAPTER 14 Valuation of Interest Rate Derivative Instruments Learning Outcomes Summary Overview Problems

CHAPTER 15 General Principles of Credit Analysis Learning Outcomes Summary Overview Problems

CHAPTER 16 Introduction to Bond Portfolio Management Learning Outcomes Summary Overview Problems

CHAPTER 17 Measuring a Portfolio’s Risk Profile Learning Outcomes Summary Overview Problems

CHAPTER 18 Managing Funds Against a Bond Market Index Learning Outcomes Summary Overview Problems

CHAPTER 19 Portfolio Immunization and Cash Flow Matching Learning Outcomes Summary Overview Problems

92 92 92 94

98 98 99 100

106 106 107 109

114 114 114 116

119 119 120 122

129 129 130 132

140 140 140 142

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Contents

CHAPTER 20 Relative-Value Methodologies for Global Credit Bond Portfolio Management Learning Outcomes Summary Overview Problems

CHAPTER 21 International Bond Portfolio Management Learning Outcomes Summary Overview Problems

CHAPTER 22 Controlling Interest Rate Risk with Derivatives Learning Outcomes Summary Overview Problems

CHAPTER 23 Hedging Mortgage Securities to Capture Relative Value Learning Outcomes Summary Overview Problems

CHAPTER 24 Credit Derivatives in Bond Portfolio Management Learning Outcomes Summary Overview Problems

144 144 144 146

151 151 152 155

159 159 160 162

167 167 167 169

172 172 172 174

PART II Solutions CHAPTER 1 Features of Debt Securities Solutions

CHAPTER 2 Risks Associated with Investing in Bonds Solutions

183 183

186 186

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Contents

CHAPTER 3 Overview of Bond Sectors and Instruments Solutions

CHAPTER 4 Understanding Yield Spreads Solutions

CHAPTER 5 Introduction to the Valuation of Debt Securities Solutions

CHAPTER 6 Yield Measures, Spot Rates, and Forward Rates Solutions

CHAPTER 7 Introduction to the Measurement of Interest Rate Risk Solutions

CHAPTER 8 Term Structure and Volatility of Interest Rates Solutions

CHAPTER 9 Valuing Bonds with Embedded Options Solutions

CHAPTER 10 Mortgage-Backed Sector of the Bond Market Solutions

CHAPTER 11 Asset-Backed Sector of the Bond Market Solutions

CHAPTER 12 Valuing Mortgage-Backed and Asset-Backed Securities Solutions

191 191

197 197

201 201

207 207

219 219

225 225

231 231

238 238

251 251

258 258

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CHAPTER 13 Interest Rate Derivative Instruments Solutions

CHAPTER 14 Valuation of Interest Rate Derivative Instruments Solutions

CHAPTER 15 General Principles of Credit Analysis Solutions

CHAPTER 16 Introduction to Bond Portfolio Management Solutions

CHAPTER 17 Measuring a Portfolio’s Risk Profile Solutions

CHAPTER 18 Managing Funds Against a Bond Market Index Solutions

CHAPTER 19 Portfolio Immunization and Cash Flow Matching Solutions

CHAPTER 20 Relative-Value Methodologies for Global Credit Bond Portfolio Management Solutions

CHAPTER 21 International Bond Portfolio Management Solutions

264 264

270 270

281 281

287 287

290 290

298 298

307 307

311 311

316 316

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Contents

CHAPTER 22 Controlling Interest Rate Risk with Derivatives Solutions

CHAPTER 23 Hedging Mortgage Securities to Capture Relative Value Solutions

CHAPTER 24 Credit Derivatives in Bond Portfolio Management Solutions

About the CFA Program

324 324

331 331

335 335

343

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LEARNING OUTCOMES, SUMMARY OVERVIEW, AND PROBLEMS

I

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1

FEATURES OF DEBT SECURITIES LEARNING OUTCOMES After reading Chapter 1 you should be able to: • • • • • • • • • •

• •

describe the basic features of a bond (e.g., maturity, par value, coupon rate, bond redeeming provisions, currency denomination, issuer or investor granted options). describe affirmative and negative covenants. identify the various coupon rate structures, such as fixed rate coupon bonds, zero-coupon bonds, step-up notes, deferred coupon bonds, floating-rate securities. describe the structure of floating-rate securities (i.e., the coupon formula, interest rate caps and floors). define accrued interest, full price, and clean price. describe the provisions for redeeming bonds, including the distinction between a nonamortizing bond and an amortizing bond. explain the provisions for the early retirement of debt, including call and refunding provisions, prepayment options, and sinking fund provisions. differentiate between nonrefundable and noncallable bonds. explain the difference between a regular redemption price and a special redemption price. identify embedded options (call option, prepayment option, accelerated sinking fund option, put option, and conversion option) and indicate whether each benefits the issuer or the bondholder. explain the importance of options embedded in a bond issue. identify the typical method used by institutional investors to finance the purchase of a security (i.e., margin or repurchase agreement).

SUMMARY OVERVIEW • • • • •

A fixed income security is a financial obligation of an entity (the issuer) who promises to pay a specified sum of money at specified future dates. Fixed income securities fall into two general categories: debt obligations and preferred stock. The promises of the issuer and the rights of the bondholders are set forth in the indenture. The par value (principal, face value, redemption value, or maturity value) of a bond is the amount that the issuer agrees to repay the bondholder at or by the maturity date. Bond prices are quoted as a percentage of par value, with par value equal to 100.

3

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Learning Outcomes, Summary Overview, and Problems

•

The interest rate that the issuer agrees to pay each year is called the coupon rate; the coupon is the annual amount of the interest payment and is found by multiplying the par value by the coupon rate. Zero-coupon bonds do not make periodic coupon payments; the bondholder realizes interest at the maturity date equal to the difference between the maturity value and the price paid for the bond. A floating-rate security is an issue whose coupon rate resets periodically based on some formula; the typical coupon formula is some reference rate plus a quoted margin. A floating-rate security may have a cap, which sets the maximum coupon rate that will be paid, and/or a floor, which sets the minimum coupon rate that will be paid. A cap is a disadvantage to the bondholder while a floor is an advantage to the bondholder. A step-up note is a security whose coupon rate increases over time. Accrued interest is the amount of interest accrued since the last coupon payment; in the United States (as well as in many countries), the bond buyer must pay the bond seller the accrued interest. The full price (or dirty price) of a security is the agreed upon price plus accrued interest; the price (or clean price) is the agreed upon price without accrued interest. An amortizing security is a security for which there is a schedule for the repayment of principal. Many issues have a call provision granting the issuer an option to retire all or part of the issue prior to the stated maturity date. A call provision is an advantage to the issuer and a disadvantage to the bondholder. When a callable bond is issued, if the issuer cannot call the bond for a number of years, the bond is said to have a deferred call. The call or redemption price can be either fixed regardless of the call date or based on a call schedule or based on a make-whole premium provision. With a call schedule, the call price depends on when the issuer calls the issue. A make-whole premium provision sets forth a formula for determining the premium that the issuer must pay to call an issue, with the premium designed to protect the yield of those investors who purchased the issue. The call prices are regular or general redemption prices; there are special redemption prices for debt redeemed through the sinking fund and through other provisions. A currently callable bond is an issue that does not have any protection against early call. Most new bond issues, even if currently callable, usually have some restrictions against refunding. Call protection is much more absolute than refunding protection. For an amortizing security backed by a pool of loans, the underlying borrowers typically have the right to prepay the outstanding principal balance in whole or in part prior to the scheduled principal payment dates; this provision is called a prepayment option. A sinking fund provision requires that the issuer retire a specified portion of an issue each year. An accelerated sinking fund provision allows the issuer to retire more than the amount stipulated to satisfy the periodic sinking fund requirement. A putable bond is one in which the bondholder has the right to sell the issue back to the issuer at a specified price on designated dates. A convertible bond is an issue giving the bondholder the right to exchange the bond for a specified number of shares of common stock at a specified price.

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• • • • •

• • • • • • • •

• • • • •

• • • •

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•

• • • • •

5

Features of Debt Securities

The presence of embedded options makes the valuation of fixed income securities complex and requires the modeling of interest rates and issuer/borrower behavior in order to project cash flows. An investor can borrow funds to purchase a security by using the security itself as collateral. There are two types of collateralized borrowing arrangements for purchasing securities: margin buying and repurchase agreements. Typically, institutional investors in the bond market do not finance the purchase of a security by buying on margin; rather, they use repurchase agreements. A repurchase agreement is the sale of a security with a commitment by the seller to repurchase the security from the buyer at the repurchase price on the repurchase date. The borrowing rate for a repurchase agreement is called the repo rate and while this rate is less than the cost of bank borrowing, it varies from transaction to transaction based on several factors.

PROBLEMS 1. Consider the following two bond issues. Bond A: 5% 15-year bond Bond B: 5% 30-year bond Neither bond has an embedded option. Both bonds are trading in the market at the same yield.

Which bond will fluctuate more in price when interest rates change? Why? 2. Given the information in the first and third columns, complete the table in the second and fourth columns: Quoted price 96 1/4 102 7/8 109 9/16 68 11/32

Price per $1 of par value

Par value $1,000 $5,000 $10,000 $100,000

Dollar price

3. A floating-rate issue has the following coupon formula: 1-year Treasury rate + 30 basis points with a cap of 7% and a floor of 4.5% The coupon rate is reset every year. Suppose that at the reset date the 1-year Treasury rate is as shown below. Compute the coupon rate for the next year: First reset date Second reset date Third reset date Fourth reset date Fifth reset date Sixth reset date Seventh reset date Eighth reset date Ninth reset date Tenth reset date

1-year Treasury rate 6.1% 6.5% 6.9% 6.8% 5.7% 5.0% 4.1% 3.9% 3.2% 4.4%

Coupon rate ? ? ? ? ? ? ? ? ? ?

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Learning Outcomes, Summary Overview, and Problems

4. An excerpt from the prospectus of a $200 million issue by Becton, Dickinson and Company 7.15% Notes due October 1, 2009: OPTIONAL REDEMPTION We may, at our option, redeem all or any part of the notes. If we choose to do so, we will mail a notice of redemption to you not less than 30 days and not more than 60 days before this redemption occurs. The redemption price will be equal to the greater of: (1) 100% of the principal amount of the notes to be redeemed; and (2) the sum of the present values of the Remaining Scheduled Payments on the notes, discounted to the redemption date on a semiannual basis, assuming a 360-day year consisting of twelve 30-day months, at the Treasury Rate plus 15 basis points. a. What type of call provision is this? b. What is the purpose of this type of call provision? 5. An excerpt from Cincinnati Gas & Electric Company’s prospectus for the 10 1/8% First Mortgage Bonds due in 2020 states, The Offered Bonds are redeemable (though CG&E does not contemplate doing so) prior to May 1, 1995 through the use of earnings, proceeds from the sale of equity securities and cash accumulations other than those resulting from a refunding operation such as hereinafter described. The Offered Bonds are not redeemable prior to May 1, 1995 as a part of, or in anticipation of, any refunding operation involving the incurring of indebtedness by CG&E having an effective interest cost (calculated to the second decimal place in accordance with generally accepted financial practice) of less than the effective interest cost of the Offered Bonds (similarly calculated) or through the operation of the Maintenance and Replacement Fund. What does this excerpt tell the investor about provisions of this issuer to pay off this issue prior to the stated maturity date? 6. An assistant portfolio manager reviewed the prospectus of a bond that will be issued next week on Ja...