CFA Level 1 (2009) - 5

Book S - Fixed Income, Derivative, and Alternative Invesunents

. Readings and Learning Outcome Statements

•LEARNING OUTCOME STATEMENTS (LOS)

The CFA Institute Learning Outcome Statements are listed below. These rlre repeated in e(Jch topic review; however, the order may have been changed in order to get a better fit with the flow ofthe review.

;S~UD~ SESSION i5~~

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The topical coverage corresponds with the following CFA Institute assigned reading:

60. Features of Debt Securities

The candidate should be able to:

a.explain the purposes of a bond's indenture, and describe affirmative and negative covenants. (page 1])

b.describe the basic features of a bond, the various coupon rate structures, and the structure of Roating-rate securities. (page 1 1)

Co define accrued interest, full price, and clean price. (page 13)

d. explain the provisions for redemption and retirement of bonds. (page 14)

e.identity the common options embedded in a bond issue, explain the importance

of embedded options, and state whether such options benefit the issuer or the bondholder. (page 16)

f.describe methods used by institutional investors in the bond market to finance the purchase of it security (i.e., margin buying and repurchase agreements). (page 17)

The topical coverage corresponds with the following (rA Institute assigned reading:

61. Risks Associated with Investing in Bonds The candidate shoul d be able to:

a.explain the risks associated with investing in bonds. (page 24)

b.identify the relations among a bond's coupon rate, the yield required by the market, and the bond's price relative to par value (i.e., discount, premium, or equal to par). (page 26)

c.explain how features of a bond (e.g., maturity, coupon, and embedded options)

and the level of a bond's yield affect the bond's interest rate risk. (page 27)

d.identify the relationship among the price of a callable bond, the price of an

option-free bond, and the price of the embedded call option. (page 28)

e.explain the interest rate risk of a floating-rate security and why such a security's

price may differ from par value. (page 28)

f. compute and interpret the duration and dollar duration of a bond. (page 29)

g.describe yield curve risk and explain why duration does not account for yield curve risk for a portfolio of bonds. (page 31)

h.explain the disadvantages of a callable or prepayable security to an investor. (page 32)

I.identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities. (page 33)

J.describe the various forms of credit risk and describe the meaning and role of

credit ratings. (page 33)

Ie explain liquidity risk and why it might be important to investors even if they expect to hold a security to the maturity date. (page 35)

Book 5 - Fixed Income, Derivative, and Alternative Investments

Readings and Learning Outcome Statements

I.describe the exchange rate risk an investor faces when a hand makes payments in a foreign currency. (page 35)

m.explain inflation risk. (page 36)

n.explain how yield volatility affects the price of a bond with an embedded option and how changes in volatility aflect the value of a callable bond and a purahle bond. (page 36)

o.describe the various forms of event risk. (page 36)

Jill' topical covemge cormponds with the following CrA Institute assigned reading:

62. Overview of Bond Sectors and Instruments The candidate should be able to:

a.describe the features, credit risk characteristics, and distribution methods for government securities. (page 45)

b.describe the types of securities issued by the U.S. Department of the Treasury (e.g. bills, notes, bonds, and inflation protection securities), and differentiate between on-the-run and off-the-run Treasury securities. (page 46)

c.describe how stripped Treasury securities are created and distinguish hetween coupon strips and principal strips. (page 48)

d.describe the types and characteristics of securities issued by U.S. federal agencies. (page 48)

e.describe the types and characteristics of mortgage-backed securities and explain the cash flow, prepayments, and prepayment risk for each type. (page 49)

f.state the motivation for creating a collateralized mortgage obligation. (page 51)

g.describe the types of securities issued by municipalities in the United States, and distinguish between tax-backed debt and revenue bonds. (page 52)

describe the characteristics and motivation for the various types of debt issued by corporations (including corporate bonds, medium-term notes, structured notes, commercial paper, negotiable CDs, and hankers acceptances). (page 5.1)

I.define an asset-backed security, describe the role of a special purpose vehicle

in an asset-backed security's transaction, state the motivation for a corporation to issue an asset-backed security, and describe the types of external credit enhancements for asset-backed securities. (page 58)

J.describe collateralized debt obligations. (page 59)

k.describe the mechanisms available for placing bonds in the primary market and differentiate the primary and secondary markets in bonds. (page 59)

The topical coverage corresponds with the following CFA Institute assigned reading:

63. Understanding Yield Spreads The candidate should be able to:

a.identify the interest rate policy tools available to a central bank (e.g., the U.S.

Federal Reserve). (page 67)

b. describe a yield curve and the various shapes of the yield curve. (page 68)

c.explain the basic theories of the term structure of interest rates and describe the

implications of each theory for the shape of the yield curve. (page 69)

d.define a spot rate. (page 71)

e.compute, compare, and contrast the various yield spread measures. (page 72)

f.describe a credit spread and discuss the suggested relation between credit spreads and the well-being of the economy. (page 73)

Book 5 - Fixed Income, Derivative, and Alternative Investments

Readings and Learning Outcome Statements

I. compute the after-tax yield of a taxable security and the tax-etIuivalent yield of a tax-exempt security. (page 74)

J.dellne LIBOR and explain its importance to funded investors who borrow shorr term. (page 75)

STUDY SESSION 16

:rhe topical cOlJerage cormponds with the following CFA Institute assigned reading:

64. Introduction to the Valuation of Debt Securities The candidate should be able to:

a.explain the steps in the bond valuation process. (page 84)

b.identify the types of bonds for which estimating the expected cash Haws is difficult, and explain the problems encountered when esrimating the cash Rows for these bonds. (page 84)

c.compute the value of a bond and the change in value that is attributable to a change in the discount rate. (page 85)

d.explain how the price of a bond changes as the bond approaches its maturity date, and compute the change in value that is attributable [Q the passage of time. (page 88)

e.compute the value of a zero-coupon bond. (page 89)

f.explain the arbitrage-free valuation approach and the market process that forces the price of a bond toward its arbitrage-free value, and explain how a dealer can generate an arbitrage profit if a bond is mispriced. (page 90)

The topical coverage corresponds with the following CFA Institute assigned reading:

65. Yield Measures, Spot Rates, and Forward Rates The candidate should be able to:

a.explain the sources of return from investing in a bond. (page 98)

b.compute and interpret the traditional yield measures for fixed-rate bonds and explain their limitations and assumptions. (page 98)

c.explain the importance of reinvestment income in generating the yield computed at the time of purchase, calculate the amount of income required to generate that yield, and discuss the factors that affect reinvestment risk.

(page 105)

d.compute and interpret the bond equivalent yield of an annual-pay bond, and the annual-pay yield of a semiannual-pay bond. (page 106)

e.describe the methodology for computing the theoretical Treasury spot rate curve

and compute the value of a bond using spot rates. (page 107)

f.differentiate between the nominal spread, the zero-volatility spread, and the option-adjusted spread. (page 111)

g.describe how the option-adjusted spread aGcounts for the option cost in a bond with an embedded option. (page 113)

h.explain a forward rate, and compute spot rates from forward rates, forward rates from spot rates, and the value of a bond using forward rates. (page 114)

Book 5 - Fixed Income, Derivative, and Altcrnative Investl11<:n[s

Readings and Learning Outcome Statements

fIJe topical Covcltlge corresponds with the following CFA 1mtitllie Iw/~~ned rtl/dillg:

66. Introduction to the Measurement of Interest Rate Risk The candidate should be able to:

a.distinguish bctwecn the full valuation :qJIHoach (the scenario analysis approach) :lI1d the duration!convexity approach ror mcasuring interest rate risk, and

explain the advantage of using the full valuation approach. (page 131)

h.demonstrate the price vo!atiliry characteristics for option-frce, callahle,

prep:lyablc, and putahle bonds when inrer<:st r:lles change. (page I T-3)

c.d<:scribe positjv<: convexity, negative convexity, and their relation to bond price and yield. (page 133)

d.compute and interpret the effective Juration of a bond, given information about how the bond's price will increase Jnd decreJse for given changes in interest rates, and compure the approximate percentage price change for a bond, given the bond's effeClive duration and a specified change in yield. (page 136)

e.distinguish among the alternative definitions of duration, and eXIJlain why

effective durJtion is the most appropriate me:lsure of intCl'est rate risk for honds wi th em bedded olnions. (page I Y))

r. compute the duration of a pord'olio, givc'n the duration of the b<mds comprising the porrtlJlio, and explain the limitations of portfolio duration. (page 1;j(J)

g.describe the convexity measure of a bond and estimate a bond's percentage price change, given the bond's duration and convexity and a specified change in interest rates. (page 141)

h.dilTerentiate b<::tween modified convexity and effective convexity. (page 143)

I.com pu te lhe price value of a basis poi n t (PVB P), and explai nits relationsh ip to duration. (page [44)

STUDY SESSION 17

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The topical covemge corresponds with the following CFA Institute rl5signed reading:

67. Derivative Markets and Instruments The candidate should be able to:

a.define a derivative and differentiate between exchange-traded and over-the- counter derivatives. (page 158)

b.define a forward commitment and a contingent claim, and describc the basic characteristics of forward contracts, futures contracts, options (calls and purs),

and swaps. (page 158)

c. discuss the purposes and criticisms of derivative markets. (page 159)

d.explain arbitrage and the role it plays in determining prices and promoting market efficiency. (page 159)

The topical coverage corresponds with the fOllowing CFA Institute assigned reading:

68. Forward Markets and Contracts The candidate should be able to:

a.differentiate between the positions held by the long and shon parties to a

forward contract in terms of delivery/settlement and default risk. (page 164)

b.describe the procedures for settling a forward contract at expiration, and discuss how termination alternatives prior to expiration can affect credit risk. (page 1(;5)

zero-coupon and coupon bonds. (page 167)

Book S - fixed Income, Derivative, and Alternative Investments

Readings and Learning Outcome Statements

e.describe the characteristics of the Euro10llar time deposit market, and define

LIBOR and Euribor. (page 169)

f.describe the characteristics of forward rate agreements (FRAs). (page 169)

g.calculate and inrerpret the payoff of an FItA and explain each of the component terms. (page 170)

h.describe the characteristics of currency forward contracts. (page 172)

The topical coverage corresponds with the following erA Institute assigned readillg:

69. Futures Markets and Contracts The candidate should be able to:

a.describe the characteristics of futures contracts, and distinguish between futures contracts and forward contracts. (page 179)

b.differentiate between margin in the securities markets and margin in the futures markets, and define initial margin, mainrenance margin, variation margin, and settlement price. (page 180)

c.describe price limits and the process of marking to market, and compute and interpret the margin balance, given the jJrevious day's halance and the change in the futures price. (page 182)

d.describe how a futures C011lracr can he terminated at or prior (0 expiration by a close-our (i.e., ofTset), a delivery, an equivalent cash senlement, or an exchange- for-physicals. (page 183)

e.describe the characreristics of the following types of futures contracts: Eurodollar, Treasury bond, srock index, and currency. (page 184)

The topical coverage corresponds with the following CFA Institute assigned reading:

70. Option Markets and Contracts The candidate should be able to:

a.define European option, American option, and moneyness, and differentiate between exchange-traded options and over-the-counter options. (page 192)

identify the types of options in terms of the underlying instruments. (page 194)

c.compare and con trast interest rate options to forward rate agreements (FRAs). (page 195)

d.define interest rate caps, floors, and collars. (page 196)

e.compute and interpret option payoffs, and explain how interest rate option

payoffs differ from the payoffs of other types of options. (page 197)

f.define intrinsic value and time value, and explain their relationship. (page 198)

g.determine the minimum and maximum values of European options and American options. (page 20 I)

h.calculate and interpret the lowest prices of European and American calls and

puts based on the ru les for minimum values and lower bounds. (page 20 I)

I.explain howoption prices are affected by the exercise price and the time to expiration. (page 206)

J.explain put-call parity for European options, and relate pur-call parity to arbitrage and the construction of synthetic options. (page 207)

k.contrast American options with European options in terms of the lower bounds

on option prices and the possibility of early exercise. (page 209)

I.explain how cash flows on the underlying asset affect put-call parity and the lower bounds of option prices. (page 210)

indicate the directional effect of an interest rate change or volatility change on an option's price. (page 210)

Book 5 - Fixed Income, Derivative, and Alternative Investments

Readings and Learning Outcome Statements

n,e topicd coverage cormponds with the following CFA Institute assigned reading:

I

71. Swap Markets and Contracts The candidate should be able to:

a.describe the charaCl<::ristics of swap cOlHracts and explain how swaps are terminated. (page 219)

b.define and give examples of currency swaps, plain vanilla interest rate swaps, and equity swaps, and calculate and iIHerprct the paymelHs on each. (page 220)

"jjJe topical cOI/erage corresponds with the following CFA Institute flssigJ1('d reading:

72. Risk Management Applications of Option Strategies The candidate should be able to:

a.determine the value at expiration, profit, maximum profit, maximum loss, breakeven underlying price at expiration, and general shape of the graph of the strategies of buying and selling calls and puts, and indicate the market outlook of investors using these strategies. (page 232)

b.determine the valuc at expiration, profit, maximum profit, maximum loss, breakeven underlying price at expiration, and gcneral shape of the graph of a covered call strategy and a protective put strategy, and explain the risk

managemelH application of each strategy. (page 235)

STUDY SESSION 18-'

The topical coverage corresponds with the following CfA Institute assigned redding:

73.Alternative Investments

The candidate should be able to:

a.differentiate between an open-end and a dosed-end fund, and explain how net asset value of a fund is calculated and the nature of fc.es charged by investmcnt companies. (page 241)

b.distinguish among style, sector, index, global, and stable value strategies in equity investment and among exchange traded funds (ETI~s), traditional mu[Ual

funds, and closed end funds. (page 244)

c. explain the advantages and risks of ETFs. (page 245)

d. describe the forms of real estate investment and explain their characteristics as an investable asset class. (page 246)

e. describe the various approaches to the valuarion of real estate. (page 247)

f.calculate rhe net operating income (NOI) from a real estate investment, the value of a propeny using the sales comparison and income approaches, and the after-rax cash flows, net present value, and yield of a real esrate investment. (page 248)

g.explain rhe srages in venture capiral invesring, venture capiral investment characteristics, and challenges to venture capiral valuation and performance measurement. (page 251)

h.calculate rhe net presenr value (NPY) of a venture capital project, given the

projecr's possible payoff and conditional failure probabiliries. (page 252)

I.discuss the descriptive accuracy of the term "hedge fund," define hedge fund in terms of objectives, legal srructure, and fcc srrucrure, and describe rhe various

Book 5 - fixed Income, Derivative, and Alternative Investments

Rcadings and Learning Outcomc Statements

I.discuss the performance of hedge funds, the biases present in hedge fund performance measurement, and explain the etTeer of survivorship bias on the reported return :lnd risk measures for :I hedge fund dat:lbase. (page 255)

nl. explain how the legal environment affects the valuation of closely held companies. (page 257)

n.describe alternative valuation methods for closely held companies and distinguish among the bases for lhe discounts and premiums for these companies. (p:lge 2')7)

o.discuss disrressed securities investing and compare vemure capital investing with distressed securities investing. (page 258)

p.discuss the role of commodities as a vehicle for investing in production and consumption. (page 258)

q.expl:J.in the motivation for investing in commodities, commodities derivatives, and commodity-linked securities. (page 258)

1'. discuss the sources of return on a collateralized commodity futures position. (page 259)

7/;" topierzL covcmge correspunds !uitlJ the folLowing CI~1 Institllte tIJ,iigllCd refuling:

74. Investing in Commodities

The candidate should be able to:

a.explain the relationship between Spot prices and expected future prices in terms of contango and backwardation. (page 275)

b.descrihe the sources of return and risk for a commodity investment and the

effect on a portfolio of adding a long-term commodity class. (page 276)

c.explain why even a commodity index strategy should be considered an active investment. (page 277)

The following is a revicw of the Analysis of Fixcd Incomc Investmcnts principlcs designed to addrcss thc learning outcome statements set forth by CFA Institute(o,). This topic is also covered in:

I

FEATURES OF DEBT SECURITIES

Study Session 15

EXAM Focus

LOS 60.a: Explain the purposes of a bond's indenture, and describe affirmative and negative covenants.

The contract that specifics all the rights and obligations of the issuer and the owners of a fixed income security is called the bond indenture. The indenture defines the obligations of and restrictions on the borrower and forms the basis for all future transactions between the bondholder and the issuer. These contract provisions are known as covenants and include both negative covenants (prohibitions on the borrower) and affirmative covenants (actions that the borrower promises to perform) sections.

Negative covenants include restrictions on 3.sset sales (the company can't sell assets that have been pledged as collateral), negative pledge of collateral (the company can't claim that the same assets back several debt issues simultaneously), and restrictions on additional borrowings (the company can't borrow additional money unless certain financial conditions are met).

Affirmative covenants include the maintenance of certain financial ratios and the timely payment of principal and interest. For example, the borrower might promise to maintain the company's current ratio at a value of two or higher. If this value of the current ratio is not maintained, then the bonds could be considered to be in (technical) default.

Describe the basic fcattlfcs of a bond, the various coupon rate structures, and the structure of floating-rate securities.

A "straight" (option-free) bond is the simplest case. Consider a Treasury bond that has a 6% coupon and matures five years from today in the amount of $1,000. This bond is a