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is the constant basis point spread added to the default-free spot
curve to correctly price a risky bond. A Z-spread of 100bps for a
particular bond would imply that adding a fixed spread of 100bps to the
points along the spot yield curve will correctly price the bond. A
higher Z-spread would imply a riskier bond.
The minimum value of a convertible bond is equal to the greater of the
conversion value of the convertible bond (i.e., Bond #9) and the
current value of the straight bond (i.e., Bond #10).
From a lender's perspective, balloon risk refers to the risk that a
borrower will not be able to make the balloon payment when due. Since
the term of the loan will be extended by the lender during the workout
period, balloon risk is a type of extension risk. Extension risk is the
undesired lengthening in the expected life of a security.
can be exercised only at specific predetermined dates
par value / conversion ratio
Value of capped floater = Value of straight bond - Value of embedded cap
CMBS investors have call protection at two levels, the structural
level and the loan level. A sequential-pay tranche is a structural level
feature that provides call protection, whereas defeasance and yield
maintenance charges are loan level call protection features.
Value of floored floater = Value of straight bond + Value of embedded floor
participants have a preferred maturity for asset purchases, but may
deviate from it if they feel returns in other maturities offer
sufficient compensation for leaving their preferred maturity segment.
Effective duration indicates the sensitivity of a bond's price to a
100 bps parallel shift of the benchmark yield curve assuming no change
in the bond's credit spread. The effective duration of an option-free
bond such as Bond #3 changes very little in response to interest rate
movements. As interest rates rise, a call option moves out of the money,
which increases the value of the callable bond and lengthens its
effective duration. In contrast, as interest rates rise, a put option
moves into the money, whi
The motivation for the creation of different types of structures is to
redistribute prepayment risk and credit risk efficiently among
different bond classes in the securitization. Typically prepayment risk
increases as interest rates drop. Credit risk is lower for senior bond
classes than for subordinated bond classes.
Support tranches reduce both the extension and contraction risk of the
PAC tranches. Support tranches do not receive any principal until the
PAC tranches receive their planned principal repayment (extension risk).
The support tranches absorb any principal repayments in excess of the
PAC tranches' planned principal repayment (contraction risk).
(OAS) is the constant spread added to all the one-period forward rates
that makes the arbitrage-free value of a risky bond equal to its market
price. The OAS approach is often used to assess bond relative values.
If two bonds have the same characteristics and credit quality, they
should have the same OAS. If this is not the case, the bond with the
largest OAS (i.e., Bond #2) is likely to be underpriced (cheap) relative
to the bond with the smallest OAS (Bond #1).
is the difference between a Libor rate and the US T-Bill rate of
matching maturity. It is an indicator of perceived credit risk in the
general economy.
bond market participants are limited to purchase of maturities that match the timing of their liabilities.
Through the lessening of the role of intermediaries, the costs paid by
the borrowers can be effectively lowered while the risk-adjusted
returns to the ultimate investors can be enhancedThrough the creation of
tranches, securitization improves liquidity relative to the underlying
assets, despite having a more complex structure.Securitization lowers or
removes the wall between borrowers and the ultimate investor through
disintermediation. This provides investors with securities that better
suit their interest
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