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Fixed Income Final
Extension risk (interest rate goes up)Â is mainly the result of rising interest rates, and is generally associated with mortgage-related securities. The opposite is contractionÂ risk, which generally occurs in a declining interest rate environment (interest rate goes down), and is associated with people paying off their loans too quickly.

Synthetic Coupon Pass Through: Suppose \$1 billion of pass-throughs and with a 6% coupon rate, used to create 2 securities. 6% is prevailing mortgage rate, A and B created as follows: A receives 75% of interest rate and 75% of principal; B receives 25% of interest rate and 50% of principal. Principal for the issues and the interest issuance is: A and B: principal = \$1 billion * 0.5 = \$500,000, A interest: 0.06 * 0.75 * 1 billion = 45 million, B interest: 0.06 * 0.25 * 1 billion = 15 million. The synthetic coupon rate for the two securities is: A: 45 million/500 million = 9%, B: 15 million/500 million = 3%

ABS (Asset Backed Security): securities created by pooling loans than first-lien mortgage loans, assets such as loans, leases,Â credit card debt, a companys receivables,Â royalties and so on and not mortgage-based securities. Asset-backed securities give the issuers of these securities a way to generate more cash, which, in turn, is used for more lending while giving investors the opportunity to invest in a wide variety of income-generating assets. Steps: 1. Originate loan 2. Issue ABS through special purpose vehicle: the ABS issuer, 3. Credit enhancements (device to revise credit risk

SPV: owns the receivable, not the loan originator, making ABS independent of loan originator
Duration of Levered Portfolio: Suppose that the initial value of an unlevered portfolio of Treasury securities is \$200 million and the duration is 7. Suppose further that the manager can borrow \$800 million and invest it in the identical Treasury securities so that the levered portfolio has a value of \$1 billion. What is the duration of this levered portfolio? Step 1: Duration of the levered portfolio = 7 (given), Step 2: 7(0.05)(\$1 billion) = \$35 million (7 times 0.5% = 3.5% change for a 50-basis-point move times \$1 billion). Step 3: The ratio of the dollar duration for a 50-basis-point change in interest rates to the \$200Â million initial market value of the unlevered portfolio is \$35 million / \$200 million .175. Step 4: The duration of the unlevered portfolio is: ratio computed in Step 3 Ă— 100/rate changed in step 2 Ă— 100 = .175 * (100/50) *100 = 35 years, The levered portfolioâ€™s value will change by (7/100)(\$1billion) = \$70 million \$70 million/\$200 million = .35 x 100 = 35 years

Creating Leverage with Repo: Suppose a manager wants to finance \$50 million of a Treasury security with a repo at a 4.2% repo rate. The repo term is 20 days. What is the dollar interest cost that the manager will have to pay for the borrowed funds? Dollar Interest = x, x