Participants In The Mortgage Market

In addition to the ultimate lenders of funds and the government agencies described in the next chapter, there are three groups involved in the market mortgage originators, mortgage servicers, and mortgage insurers. The original lender is called the mortgage originator. Mortgage originators include thrifts, commercial banks, mortgage bankers, life insurance companies, and pension funds. The three largest originators for all types of residential mortgages are thrifts, commercial banks, and...

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The mortgage balance at the end of month 1 (beginning of month 2) is then'' 99,934.59 ( 100,000 minus 65.41). The interest for the second monthly mortgage pay , ment is 676.64, th& monthly interest rate (0.0066708) times the mortgage balance at the beginning of month 2 ( 99,934.59). The difference between the 742.50 monthly mort gage payment and the 676.64 interest is 65.86, representing the amount of the mttfcg gage balance paid off with that monthly mortgage payment. Notice that the last...

Individual Security Selection Strategies

There are several active strategies that money managers pursue to identify mispriced securities. The most common strategy identifies an issue as undervalued because either (1) its yield is higher than that of comparably rated issues, or (2) its yield is expected to decline (and price therefore rise) because credit analysis indicates that its rating will improve. A swap in which a money manager exchanges one bond for another bond that is similar in terms of coupon, maturity, and credit quality,...

Questions

Suppose you are told that the cash flow yield of a pass-through security is 9 and that you are seeking to invest in a security with a yield greater than 8.8 . a. What additional information would you need to-know before you might invesj in this pass-through security I b. What are the limitations of the cash flow yield for assessing the potential return from investing in a mortgage-backed security CHAPTER IS Analysis of Mortgage-Backed Securities 387 Using the cash flow yield methodology, a...

Mortgage Pass Through Securities

After reading this chapter you will understand what a mortgage pass-through security is the cash flow characteristics of mortgage pass-through securities the importance of prepayments projections in estimating the cash flow of a mortgage pass-through security the WAC and WAM of a pass-through security the different types of agency pass-through securities what nonagency pass-through securities are and the different ways in which they can be credit enhanced what the PSA prepayment benchmark is...

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This excerpt, which discusses dual currency bonds, is taken from the International Capital Market, published in 1989 by the European Investment Bank The generic name of dual-currency bonds hides many different variations which are difficult to characterize in detail. These variations on the same basic concept have given birth to specific names like Index Currency Option notes (ICON), foreign interest payment bonds (FIPS), forex-linked bonds, heaven and hell bonds, to name but a few. Despite...

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IV(0.5869) 0.7214 and Af(0.4455) 0.6720 C 83.96(0.7214) - 88 e (OO6)(2)(0.6720) 8,116 There is no reason to suspect that this estimated value is unreasonable. However, let's change the problem slightly. Instead of a strike price of 88, let's make the strike price 100.25. Substituting the new strike price into equations (22.7) and (22.8) d ln(83.96 100.25) + 0.06 + 0.5(0.10) _03346 1 0.10V2 mi, mm pmr Mil imi sa wsm CHAPTER 22 Interest-Rate Options 55 I W(-0.3346) 0.3689 and (-0.4761) 0.3170...

The Costs Of Cash Flow Matching Gifford Fong

The nature of their liabilities, as well as regulatory considerations, determines the investment strategy pursued by all institutional investors. By nature, liabilities vary with respefit to the amount and timing of their payment. The liabilities will generally fall into one of the four types shown in Exhibit 19-1. , Surplus management is a more appropriate description of the activity of asset liability management of an institution. The economic surplus of any entity is the differ- l6The Costs...

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Foreign bonds in the United Kingdom are referred to as bulldog bonds, in the Netherlands as Rembrandt bonds, and in Spain as matador bonds. Regulatory authorities in the country where the bond is issued impose certain rules governing the issuance of foreign bonds. These may include (1) restrictions on the bond structures that may be issued (e.g., unsecured debt, zero-coupon bonds, convertible bonds, and so on), (2) restrictions on the minimum or maximum size of an issue and or the frequency...

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In a discussion of the CMO market, the popular press sometimes refers to this sector of the mortgage-backed securities market as the riskiest sector and the pass-through sector as the safest sector. Comment. 5. Explain the effect on the average lives of sequential-pay structures of including an accrual tranche in a CMO structure. 6. What types of investors would be attracted to an accrual bond 7. Suppose that a tranche from which an inverse floater is created has an average life of five years....

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CHAPTER 21 Interest-Rate Futures Contracts 527 tures contract (1) In the cash market ABC is selling for 80 (par value is 100) (2) ABC pays 8 in coupon interest per year in two semiannual payments of 4, and the next semiannual payment is due exactly six months from now and (3) the current six-month interest rate at which funds can be loaned or borrowed is 6 . a. What is the theoretical futures price b. What action would you take if the futures price is 83 c. What action would you take if the...

To Satisfy Multiple Liabilities

Thus far we have discussed immunizing a single liability. For pension funds, there are multiple liabilities that must be satisfied payments to the beneficiaries of the pension fund. A stream of liabilities must also be satisfied for a life insurance company that sells an insurance policy requiring multiple payments to policyholders, such as an annuity policy. There are two strategies that can be used to satisfy a liability stream (1) multiperiod immunization, and (2) cash flow matching. 468...

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And the Inter-American Development Bank. The general objective of the former is to improve the efficiency of the international financial and trading markets. The objective of the latter supranational is to promote economic growth in the developing countries of the Americas. Securities Issued in the Eurobond Market The Eurobond market has been characterized by new and innovative bond structures to accommodate particular needs of issuers and investors. There are of course, the plain vanilla,...

Summary

There are five basic steps in investment management. The first and principal step in the investment management process is setting investment objectives. The second step is establishing policy guidelines to satisfy the investment objectives it begins with the asset allocation decision. The third step is selecting a portfolio strategy that is consistent with the objectives and policy guidelines of the client or institution. The fourth step is selecting the specific assets to be included in the...

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CHAPTER 23 Interest-Rate Swaps and Agreements 581 The coupon rate is set every six months. The risk that the life insurance company faces in this instance is that six-month LIBOR will fall so that the company will not earn enough to realize a spread over the 9 rate that it has guaranteed to the GIC holders. If six-month LIBOR falls to 7.4 or less, no spread income will be generated. To understand why, suppose that six-month LIBOR at the date the floating-rate instrument resets its coupon is 7.4...

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CHAPTER 20 Bond Performance Measurement and Evaluation 481 RP return on the portfolio MV portfolio market value at the end of the evaluation period MV0 portfolio market value at the beginning of the evaluation period D - cash distributions from the portfolio to the client during the evaluation period To illustrate the calculation of a return, assume the following information for an external manager for a pension plan sponsor The portfolio's market value at the beginning and end of the...

Exchangetraded Futures Options

An option on a futures contract, commonly referred to as a futures option, gives the buyer the right to buy from or sell to the writer a designated futures contract at a designated price at any time during the life of the option. If the futures option is a call option, the buyer has the right to purchase one designated futures contract at the exercise price. That is, the buyer has the right to acquire a long futures position in the designated futures contract. If the buyer exercises the call...

Selecting a Portfolio Strategy

Selecting a portfolio strategy that is consistent with the objectives and policy guidelines of the client or institution is the third step in the investment management process. Portfolio strategies can be classified as either active strategies or passive strategies. Essential to all active strategies is specification of expectations about the factors that influence the performance of an asset class. In the case of active equity strategies, this may include forecasts of future earnings,...

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CHAPTER 7 Corporate Debt Instruments I 73 holders, generally must approve the plan of reorganization, creditors often convince equity holders to accept the plan by offering to distribute some value to them. The recontracting process hypothesis argues that the violation of absolute priority reflects a recontracting process between stockholders and senior creditors that gives recognition to the ability of management to preserve value on behalf of stockholders.30 According to the stockholders'...

Logistical Problems In Implementing

An indexer faces several logistical problems in constructing an indexed portfolio. First, the prices for each issue used by the organization that publishes the index may not be execution prices available to the indexer. In fact, they may be materially different from the prices offered by some dealers. In addition, the prices used by organizations reporting the value of indexes are based on bid prices. Dealer ask prices, however, are the ones that the money manager would have to transact at when...

To Satisfy A Single Liability

In the balance of this chapter we focus on liability funding strategies. Tens of billions of dollars in pension monies went into these liability funding strategies in the early and mid-1980s when interest rates were high because of the strong incentive to reduce pension costs by locking in these rates. The insurance industry has also made widespread use of these strategies for their fixed-liability insurance products. We begin with a strategy referred to as an immunization strategy. The person...

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CHAPTER 11 Mortgage Pass-Through Securities 257 makes pass-through securities unattractive for certain financial institutions to hold from an asset-liability perspective. Pass-throughs are quoted in the same manner as U.S. Treasury coupon securities. They are identified by a pool prefix and pool number. A TBA trade occurs while a pool is still unspecified, and therefore no pool information is known at the time of the trade. The seller has the right in this case to deliver pass-throughs backed...

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130 CHAPTER 6 Treasury and Agency Securities Markets Dealers use interdealer brokers because of the speed and efficiency with which trades can be accomplished. With the exception of Cantor, Fitzgerald Securities Inc., interdealer brokers do not trade for their own account, and they keep the names of the dealers involved in trades confidential. The quotes provided on the government dealer screens represent prices in the inside or interdealer market. Historically, primary dealers have resisted...

Review Of Time Value Of Money

The notion that money has a time value is one of the basic concepts in the analysis of any financial instrument. Money has time value because of the opportunity to invest it at some interest rate. To determine the future value of any sum of money invested today, equation 2.1 can be used P future value n periods from now in dollars Pa original principal in dollars r interest rate per period in decimal form The expression 1 r represents the future value of 1 invested today for n periods at a...

Active Bond Portfolio Management Strategies

After reading this chapter you will understand the five basic steps involved in the investment management process the difference between active and passive strategies the importance of knowing the market consensus before implementing an active strategy the different types of active bond portfolio strategies interest-rate expectations strategies, yield curve strategies, yield spread strategies, option-adjusted spread-based strategies, and individual security selection strategies bullet, barbell,...

Stripped Treasury Securities

The Treasury does not issue zero-coupon notes or bonds. However, because of the demand for zero-coupon instruments with no credit risk, the private sector has created such securities. The profit potential for a government dealer who strips a Treasury security lies in arbitrage resulting from the mispricing of the security. We explained the reason for this in Chapter 5. In August 1982 both Merrill Lynch and Salomon Brothers created synthetic zero-coupon Treasury receipts. Merrill Lynch marketed...

Eurobond Market

The Eurobond market is divided into sectors depending on the currency in which the issue is denominated. For example, when Eurobonds are denominated in U.S. dollars, they are referred to as Eurodollar bonds. Eurobonds denominated in Japanese yen are referred to as Euroyen bonds. In recent years it has become increasingly difficult to classify a bond issue as a foreign bond or a Eurobond based on the distinguishing characteristics that we cited earlier.5 We noted that the most important...

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EXHIBIT 7-1 Oionfo-J-Scledulefor I O'i Sinking Fund Dcbencu The Debentures will be redeemable at the option of the Company at any time in whole or in part, upon not fewer than 30 nor more than 60 days' notice, at the following redemption prices which are expressed in percentages of principal amount in each case together with accrued interest to the date fixed for redemption If redeemed during the 12 months beginning July 1, Provided, however, that prior to July 1, 1998, the Company may not...

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CHAPTER 12' Collateralized Mortgage Obligations and Stripped Mortgage-Backed Securities 285 EXHIBIT Ti-16 Relatr ns bewiS'Prra an T - 3 Mortgage Rates for a Pass-Through, -i PO, and lOJ uJ Vj j EXHIBIT Ti-16 Relatr ns bewiS'Prra an T - 3 Mortgage Rates for a Pass-Through, -i PO, and lOJ uJ Vj j Source Adapted from Steven J. Carlson and Timothy D. Sears, Stripped Mortgage Pass-Throughs New Tools for Investors, in Frank J. Fabozzi, ed., The Handbook of Mortgage-Backed Securities, rev. ed. Chicago...

Static Cash Flow Yield Methodology

The static cash flow yield methodology is the simplest to use, although we shall see that it offers little'insight into the relative value of a mortgage-backed security. It begins with the computation of the cash flow yield measure that we described for pass-throughs in Chapter 11. The cash flow yield is based on some prepayment assumption. To illustrate the cash flow yield, we'll use one of the CMO structures we developed in Chapter 12, FJF-06. This structure is summarized in Exhibit 12-15....

Inversefloatingrate Securities

The cash flow is not known for either a floating-rate or an inverse-floating-rate security it will depend on the reference rate in the future. The coupon rate of a floating-rate security or floater is equal to a reference rate plus some spread or margin. For example, the coupon rate of a floater can reset at the rate on a three-month Treasury bill the reference rate plus 50 basis points the spread . The price of a floater depends on two factors 1 the spread over the reference rate and 2 any...

Yields On Municipal Bonds

As explained in Chapter 5, a common yield measure used to compare the yield on a tax-exempt municipal bond with a comparable taxable bond is the equivalent taxable yield. The equivalent taxable yield is computed as follows equivalent taxable yield -. r, 1- For example, suppose that an investor in the 40 marginal tax bracket is considering the acquisition of a tax-exempt municipal bond that offers a yield of 6.5 . The equivalent taxable yield is 10.83 , as follows equivalent taxable yield q q...

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Source Data from Lehman Brothers and filler, Anderson amp Sherrerd, as reported in Thomas L. Bennett, Stephen F. Esser, and Christian G. Roth, Corporate Credit Risk and Reward West Conshohocken, PA Miller, Anderson amp Sherrerd, 1993 . Reprinted by permission. Source Data from Lehman Brothers and filler, Anderson amp Sherrerd, as reported in Thomas L. Bennett, Stephen F. Esser, and Christian G. Roth, Corporate Credit Risk and Reward West Conshohocken, PA Miller, Anderson amp Sherrerd, 1993 ....

Collateralized Mortgage Obligations and Stripped Mortgage Backed Securities

After reading this chapter you will understand why and how a collateralized mortgage obligation is created what a sequential-pay CMO is how the average life of a sequential-pay CMO compares to that of the collateral from which it is created what an accrual tranche is and its effect on the average life of sequential-pay tranches in the CMO structure how a floater and an inverse floater are created from a CMO tranche what a planned amortization class tranche is and how it is created how the...

Dont think of duration as a measure of time

Unfortunately, market participants often confuse the main purpose of duration by constantly referring to it as some measure of the weighted average life of a bond. This is because of the original use of duration by Macaulay. If you rely on this interpretation of duration, it will be difficult for you to understand why a bond with a maturity MflKISBH HHHI BHfffHB H HH ggpgwj a Hbbhbbi I L- IPMH RMI wm TOU MR m of 20 years can have a duration greater than 20 years. For example, in Chapter 12 we...

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CHAPTER 12 Collateralized Mortgage Obligations and Stripped Mortgage-Backed Securities 269 time as principal payments are made. The principal payments to the floater are determined by the principal payments from the tranche from which the floater is created. In our CMO structure, this is tranche C. Because the floater's par value is 72,375,000 of the 96.5 million, the balance is the inverse floater. Assuming that one-month LIBOR is the reference rate, the coupon rate on the inverse floater...

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CHAPTER 11 Mortgage Pass-Through Securities 24 I expected future economic environment. It is referred to as a conditional rate because it is conditional on the remaining mortgage balance. Single-Monthly Mortality Rate The CPR is an annual prepayment rate. To estimate monthly prepayments, the CPR must be converted into a monthly prepayment rate, commonly referred to as the single-monthly mortality rate SMM . A formula can be used to determine the SMM for a given CPR SMM 1 - 1 - CPR '2 11.1...

Suppose That The Price Of A Treasury Bill With 90 Days To Maturity And A 1 Million Face Value Is 980 000. What Is The

CHAPTER 6 Treasury and Agency Securities Markets 141 sectors of the economy. Federally related institutions are arms of the federal government whose debt is generally guaranteed by the U.S. government. 1. What are the differences among a Treasury bill, Treasury note, and Treasury bond 2. The following questions are about the Treasury Inflation Protected Security TIPS . a. What is meant by the real rate. b. What is meant by the inflation-adjusted principal. c. Suppose that the coupon rate for a...

Merrill Lynch Exponential Spline Model

Source The data points were provided by Philip H. Galdi, Analyst at Merrill Lynch, and Shenglin Lu, Analyst at Merrill Lynch. These data were used to construct the spot rate curves in Philip H. Galdi and Shenglin Lu, Analyzing Risk and Relative Value of Corporate and Government Securities, Merrill Lynch amp Co., Global Securities Research amp Economics Group, Fixed Income Analytics, 1997. Copyright 1997 Merrill Lynch, Pierce, Fenner amp Smith Incorporated. Source The data points were provided...

Bond Price Volatility

After reading this chapter you will understand the price-yield relationship of an option-free bond the factors that affect the price volatility of a bond when yields change the price-volatility properties of an option-free bond how to calculate the price value of a basis point how to calculate and interpret the Macaulay duration, modified duration, and dollar duration of a bond why duration is a measure of a bond's price sensitivity to yield changes how to compute the duration of a portfolio...

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Dividing both sides of quation 4.15 by P to get the percentage price change gives us dP dP 1, , 1 d2P -.2 , error The first term on the right-hand side of equation 4.15 is equation 4.14 that is, it is the dollar price change based on dollar duration. Thus the first term in equation 4.15 is our approximation of the price change based on deration. In equation 4.16 , 5A Taylor series, discussed in calculus textbooks, can be used to approximate a mathematical function. Here, the mathematical...

Complications

The framework for pricing a bond discussed in this chapter assumes that 1. The next coupon payment is exactly six months away. 3. The appropriate required yield can be determined. 4. One rate is used to discount all cash flows. Let's look at the implications of each assumption for the pricing of a bond. Next Coupon Payment Due in Less Than Six Months When an investor purchases a bond whose next coupon payment is due in less than six months, the accepted method for computing the price of the...

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Note that the number of periods is equal to 20 semiannual periods, which is double the number of years. The number of years is not used because we want a yield value 'That is, M is substituted for CF . that may be compared with alternative coupon bonds. To get the bond-equivalent annual yield, we must double y, which gives us 8.4 . The yield-to-maturity calculation takes into account not only the current coupon income but also any capital gain or loss that the investor will realize by holding...

Sectors Of The Us Bond Market

The U.S. bond market is the largest bond market in the world. The market is divided into six sectors U.S. Treasury sector, agency sector, municipal sector, corporate sector, asset-backed securities, and mortgage sector. The Treasury sector includes securities issued by the U.S. government. These securities include Treasury bills, notes, and bonds. The U.S. Treasury is the largest issuer of securities in the world. This sector plays a key role in the valuation of securities and the determination...

For Optionfree Bonds

As we explain in Chapter 2, a fundamental principle of an option-free bond i.e., a bond that does not have an embedded option is that the price of the bond changes in the direction opposite to that of a change in the required yield for the bond. This prin- ciple follows from the fact that the price of a bond is equal to the present value of its expected cash flows. An increase decrease in the required yield decreases increases the present value of its expected cash flows and therefore decreases...

Risks Associated With Investing In Bonds

Bonds may expose an investor to one or more of the following risks 1 interest-rate risk 2 reinvestment risk 3 call risk 4 default risk 5 inflation risk 6 ex-change-rate risk 7 liquidity risk 8 volatility risk and 9 risk risk. While each of these risks is discussed further in later chapters, we describe them briefly in the following sections. In later chapters, other risks, such as yield curve risk, event risk, and tax risk, are also introduced. The price of a typical bond will change in the...

Financial Innovation And The Bond Market

Since the 1960s, there has gt been a surge of significant financial innovations, many of them in the bond market. Observers of financial markets have categorized these innovations in different ways. For example, the Economic Council of Canada classifies financial innovations into three broad categories2 Markefcbroadening instruments, which augment the liquidity of markets and the availability of funds by attracting new investors and offering new opportunities for borrowers. 2Globalization and...

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Suppose that the price of this debt obligation is 7,704. What is the yield or internal rate of return offered by this debt obligation 2. What is the effective annual yield if the semiannual periodic interest rate is 4.3 3. What is the yield to maturity of a bond 4. What is the yield to maturity calculated on a bond-equivalent basis 5. a. Show the cash flows for the following four bonds, each of which has a par value of 1,000 and pays interest semiannually b. Calculate the yield to maturity for...

Conventional Yield Measures

There are several bond yield measures commonly quoted by dealers and used by portfolio managers. In this section we discuss each yield measure and show how it is computed. In the next section we critically evaluate yield measures in terms of their usefulness in identifying the relative value of a bond. CHAPTER 3 Measuring Yield 37 Current Yield Current yield relates the annual coupon interest to the market price. The formula for the current yield is For example, the current yield for a 15-year...

Price Volatility Characteristics Of Optionfree Bonds

Exhibit 4-3 shows for the six hypothetical bonds in Exhibit 4-1 the percentage change in the bond's price for various changes in the required yield, assuming that the initial yield for all six bonds is 9 . An examination of Exhibit 4-3 reveals several properties concerning the price volatility of an option-free bond. Property 1 Although the prices of all option-free bonds move in the opposite direction from the change in yield required, the percentage price change is not the same for all bonds....

Overview Of The Book

The next four chapters of Section I set forth the basic analytical framework necessary to understand the pricing of bonds and their investment characteristics. How the price of a bond is determined is explained in Chapter 2. The various measures of a bond's return are illustrated and evaluated critically in Chapter 3, which is followed by an explanation of the price-volatility characteristics of bonds in Chapter 4. The factors that affect the yield of a bond are explained in Chapter 5, and the...

Overview Qf Bond Features

In this section we provide an overview of some important features of bonds. A more detailed treatment of these features is presented in later chapters. The bond indenture is the contract between the issuer and the bondholder, which sets forth all the obligations of the issuer. A key feature of a bond is the nature of the issuer. There are three issuers of bonds the federal government and its agencies, municipal governments, and corporations domestic and foreign . Within the municipal and...

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Stripped Treasury Securities 134 Strips 135 CHAPTER 7 Corporate Debt Instruments 143 Corporate Bonds 144 Medium-Term Notes 164 Commercial Paper 167 Bankruptcy and Creditor Rights 171 Investors in Municipal Securities 178 Types and Features of Municipal Securities 179 Municipal Money Market Products 185 Municipal Derivative Securities 186 Credit Risk 189 Risks Associated with Investing in Municipal Securities 190 Yields on Municipal Bonds 191 Municipal Bond Market 194 Classification of Global...

Preface to the Fourth Edition

The first edition of Bond Markets, Analysis and Strategies was published in 1989. The objective was to provide coverage of the products, analytical techniques for valuing bonds and quantifying their exposure to changes in interest rates, and portfolio strategies for achieving a client's objectives. In the two editions subsequently published and in the current edition, the coverage of each of these areas has been updated. In the product area, the updating has been primarily for the latest...