BOOK 5 — FIXED INCOME AND DERIVATIVES Readings and Learning Outcome Statements... Study Session 14 ~ Fixed Income: Valuation Concepts no Study Session 15 — Fixed Income: Structured Securities ..... Self-Test ~ Fixed Income .. - 193, Study Session 16 ~ Derivatives: Forwards and Futures... - 196 Study Session 17 — Derivatives: Options, Swaps, and Interest Rate and Credit Derivatives 1 245, Self-Test ~ Derivatives a 2 334 337 343LEVEL 2 BOOK 5: FIXED INCOME AND DERIVATIVES ©2008 Kaplan Schweser. All rights reserved. Published in September 2008 by Kaplan Schweser. Printed in the United States of America. ISBN: 1-60373-226-8 / 978-1-60373-226-0 PPN: 45549CFA Tf this hook dace nor have the hologram with the Kaplan Schweser logo on che back cover, i was distributed without permission of Kaplan Schweser, a Division of Kaplan, Ine, and is in direct violation of global capyright laws, Your asistance in pursuing potential violacors ofthis law is greatly appreciated Requized CA Trait dichiner "CFA® and Chartered Financial Analya™ ae wademarks owned hy CFA Insiate. GFA Tnetiate Aorserly che Asscitin for Investment Manageme and Research) does not endorse, promote review, oF warrant the accuracy ofthe products or services offered by Kaplan Shwescr Certain materials contained within this text are the copyrighted property of CFA Institute, The following isthe capyrighdislosece for these materials; "Copyright, 2009, CEA lnstitute. Reprodiiced and republished from 2009 Learning Outcome Statements, Level 1, 2, and 3 questions from CFA® Program Matevals, CFA Institute Standards of Profesional Conduct, nd CFA Institutes Glohal Investment Performance Standards with periission from CEA Institute. All Rights Reserved.” These materials may not he copied without writen permission fram the author. The unauthorized duplication of these notes isa vinlaion of slobal copyright laws and the CEA Institute Code of Ethies. Your assistance in pursuing potential vinlacors of ghis lw is greatly appreciated Disclaimer ‘The Schweser Natex should he used in conjunction with the original reading as set forth by CFA Institute in their 2009 CA Level 2 Study Guide, The information contained in these Notes covers topics contained inthe readings referenced hy CEA Institute ad is believe ta he accurate: However their accuracy cannot be guaranteed nor is any warrancy conveyed as 10 your ultimate exam success. The auhors ofthe reference! readings have nat endared oe sponsored these Notes ”READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review of the Fixed Income and Derivatives principles designed to address the learning outcome statements set forth by CFA Institute. STUDY SESSION 14 Reading Assignments Fixed Income, CFA Program Curriculum, Volume 5, Level 2 (CFA Institute, 2008) 52. General Principles of Credit Analysis page 10 53. The Liquidity Conundrum page 39 54. Term Structure and Volatility of Interest Rates page 48 55. Valuing Bonds with Embedded Options page 75, STUDY SESSION 15 Reading Assignments Fixed Income, CFA Program Curriculum, Volume 5, Level 2 (CFA Institute, 2008) 56. Mortgage-Backed Sector of the Bond Market page 110 57. Europe's Whole Loan Sales Market Burgeoning as Morcgage Credit Market Comes of Age page 140 Bs Asset-Backed Sector of the Bond Market page 146 9. Valuing Mortgage-Backed and Asset-Backed Securities page 171 a ues o>'g COoNe( Reading Assignments Derivatives and Porefolio Management, CFA Program Curriculum, Volume 6, Level 2 (CEA Institute, 2008) G0. Forward Markets and Contracts page 196 G1. Futures Markets and Contracts page 224 STUDY SESSION 17 Reading Assignments Derivatives and Portfolio Management, CFA Program Curriculum, Volume 6, Level 2 (CEA Institute, 2008) 62. Option Markets and Contracts page 245 63. Swap Markets and Contracts page 288 G4, Interest Rate Derivative Instruments page 316 G5. Using Credit Derivatives to Enhance Return and Manage Risk page 324 ©2008 Kaplan Schweser Page 3Book 5 — Fixed Income and Derivatives Readings and Learning Ouccome Statements Page 4 LEARNING OUTCOME STATEMENTS (LOS) The CFA Institute Learning Outcome Statements are listed below. These are repeated in each topic review; however, the order may have been changed in order to get a better fit with the flow of the review. STUD ON 14 The topical coverage corresponds with the following CFA Institute assigned reading: 52. General Principles of Credit Analysis 53. The candidate should be able to: a. distinguish among default risk, credit spread risk, and downgrade risk. (page 10) b. identify, explain, and analyze the key components of credit analysis, including both the borrower and the instrument. (page 11) c. calculate, critique, and interpret the key financial ratios used by credit analysts. (page 14) d. evaluate the credit quality of an issuer of a corporate bond, given such data as key financial ratios for the issuer and the industry. (page 14) e. analyze why and how cash flow from operations is used to assess the ability of an issuer to service its debt obligations and to assess the financial flexibility of a company. (page 18) f. identify, explain, and interpret the typical elements of the corporate stracture and debe structure of a high-yield issuer and the impact of these elements on the risk position of the lender. (page 19) g. discuss the factors considered by rating agencies in rating asset-backed securities. (page 21) h. explain how the creditworthiness of municipal bonds is assessed, and contrast the analysis of rax-backed debt with the analysis of revenue obligations. (page 22) 3. discuss the key considerations used by Standard & Poor's in assigning sovereign ratings and describe why two ratings are assigned to each national government. (page 23) j. contrast the credit analysis requised for corporate bonds to that required for 1) asset-backed securities, 2) municipal securities, and 3) sovereign debr. (page 25) The topical coverage corresponds with the following CFA Institute assigned reading: ‘The Liquidity Conundrum The candidate should be able to: a. distinguish between the concept of liquidicy as “appetite for risk” as contrasted with the more traditional view that liquidity is the creation of the central bank. (page 39) b. illustrate how the default rate on a 2/28 adjustable rate subprime mortgage changes as debt creation journeys from conservative hedging activities, to more speculative activities, and finally to a Ponzi scheme phase. (page 41) c. explain how a subprime mortgage bottower is granted a free at-the-money call option on the value of their property. (page 42) ©2008 Kaplan Schweser54. 55, Book 5 ~ Fixed Income and Derivatives Readings and Learning Ourcome Statements The topical coverage corresponds with the following CFA Institute assigned reading: Term Structure and Volatility of Interest Rates ‘The candidate should be able to: a._ illustrate and explain parallel and nonparallel shifts in the yield curve, a yield curve twist, and a change in the curvature of the yield curve (i.e., a butterfly shift). (page 49) b. describe the factors that have been observed to drive U.S. Treasury security returns, and evaluate the importance of each factor. (page 50) c. explain the various universes of Treasury securities that are used to construct the theoretical spot rate curve, and evaluate their advantages and disadvantages. (page 52) d. explain the swap rate curve (LIBOR curve) and discuss the reasons that market participants have increasingly used the swap rate curve as a benchmark rather than a government bond yield curve. (page 54) ¢._ illustrate the various theories of the term structure of interest rates (i.e., pure expectations, liquidity, and preferred habitat) and the implications of each theory for the shape of the yield curve. (page 55) f. compute and interpret the yield curve risk of a security or a portfolio, using key rate duration. (page 60) g compute and interpret yield volatility. (page 61) h. distinguish between historical yield volatility and implied yield volatility. (page 63) i. explain how yield volatility is forecasted. (page 64) The topical coverage corresponds with the following CEA Institute assigned reading: Valuing Bonds with Embedded Options The candidate should be able to: a. evaluate, using relative value analysis, whether a security is undervalued or overvalued. (page 85) b. evaluate the importance of the benchmark interest rates in interpreting spread measures. (page 80) c. illustrate the backward induction valuation methodology within the binomial interest rate tree framework. (page 80) d. compute the value of a callable bond from an interest rate tree. (page 81) ¢. illustrate the relationship among the values of a callable (putable) bond, the corresponding option-free bond, and the embedded option. (page 82) f. explain the effect of volatility on the arbitrage-free value of an option. (page 83) g. interpret an option-adjusted spread with respect to a nominal spread and to benchmark interest rates. (page 85) h, illustrate how effective duration and effective convexity ate calculated using the binomial model. (page 88) i. calculate the value of a putable bond, using an interest rate tree. (page 89) j. describe and evaluate a convertible bond and its various component values. (page 91) k. compare and contrast the risk-rerurn characteristics of a convertible bond to the risk-return characteristics of ownership of the underlying common stock. (page 96) ©2008 Kaplan Schweser Page 5