46 Free CFA Level 2 Mock Exam Questions and Answers on Fixed Income

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highly predictable life for the PAC tranche- initial PAC collar gives a range- the planned amortization schedule promised to the PAC I tranche is the minimum of the two prepayment speeds

• Tranches trading at a premium
• Free operating cash flow
• Planned Amortization Class (PAC) CMO
• Sequential pay CMO

potential to change two notches

• OAS
• ratings watch
• rating outlook
• Duration

- never use nominal spread- Z-spread is only used with no prepayment bonds (autos, credit cards)- if not IR dependent, use binomial model- if dependent, use Monte Carlo

• Auto loan ABS
• OAS on an MBS
• Factors in rating ABS
• Spreads in MBS/ABS

- associated with interest rate increases and falling prepayment rates- fewer repayments, bond values fall, and investors get their principal back slower and can't reinvest

• Auto loan ABS
• rating outlook
• Contraction risk
• Extension risk

- lately, it is a 1st lien on property owned by a borrower that has a marginal credit history- closed end HELs are like normal loans- Non-accelerating senior tranches (NAS) usually don't receive prepayments early on and then receive a lot later one

• Home Equity Loan ABS
• Auto loan ABS
• Spreads in MBS/ABS
• OAS on an MBS

- increases the option costs and reduces the value of the MBS (which is short the prepayment option)

• Collateralized mortgage obligations
• Shifting interest mechanism
• Increases in the assumed interest rate volatility
• Tranches trading at a premium

- there is no credit risk (issue and and benchmark are assumed to be the same)- liquidity risk relative to issuer's other securities (typically small)- thus, since all risks are basically removed, OAS of 0 = fairly valued

• Synthetic CDO
• Credit tranching
• Spreads in MBS/ABS
• Issuer-specific benchmark

- each class of bonds is retired sequentially- last tranche is called the Z-tranche or the accrual tranche

• Sequential pay CMO
• Synthetic CDO
• Auto loan ABS
• Extension risk

- must be added to every spot rate along every interest rate path- MBS are interest rate path dependent, thus you can't use backward induction- cheap securities have high OAS relative to the required OAS and low option costs (for a given Z-spread and effective duration)

• Government debt
• OAS
• Auto loan ABS
• OAS on an MBS

- prepayments are not significant (small loans, quickly depreciating assets, low credit ratings)

• OAS on an MBS
• Spreads in MBS/ABS
• Factors in rating ABS
• Mfg housing-based ABS

- represents a claim against a pool of mortgages- passthrough rates are less than the average coupon rate due to fees- passthrough securities traded in the secondary market effectively converts illiquid mortgages into liquid securities, aka securitization

• positive butterfly shift
• Contraction risk
• Mortgage passthrough security
• Extension risk

- the discount rate that makes the price of a MBS or ABS equal to the PV of its cash flows- in order to compute this, we must make a prepayment assumption and default/recovery assumptions if a non-agency issue- has reinvestment, price, and prepayment risk

• Cash flow duration
• Cash flow yield
• OAS on an MBS
• Auto loan ABS