FIN 4243 Final

Value is equal to:

the sum of the future expected cash flows discounted at the appropriate rate of return

all else equal, a decrease in an asset's discount rate (its expected rate of return) leads to ______ in its value

an increase

Suppose an asset's cash flows become higher than currently expected. All else equal, this change would lead to ______ in the asset's value

an increase

Relative to that of a non-callable bond, the yield to maturity of callable bonds will be ________

Higher because the callable bond has a lower price than the non-callable bond with otherwise equivalent features

Suppose the interest rate volatility is lower than anticipated, which of the following statements is true?

The price would increase because lower volatility means that future cash flows are more certain

The duration of a callable bond is ________ that of an otherwise comparable non-callable bond because _____________.

Less than; callable bonds have limited upside price potential since the issuing firm will exercise the call option if the market price exceeds the call price

Callable bonds

bond with an embedded call option that allows the issuer to call the bond back at prespecified times at prespecified prices

If a bond gets called you are mainly exposed to ______ risk

reinvestment

callable bonds value are ____ than noncallable bonds

less

why would an investor buy a callable bond?

1. callable bonds are cheaper 2. if yields increase then the investor makes a higher return (because bought a cheaper price)

call option value is increased with volatility

more uncertainty, more value, higher the risk, higher the reward

if interest rate volatility goes down, then prices will go _____

up because certainty goes up

Mortgage backed securities

an example of an "asset-backed security", payments are based on the mortgage payments of commercial/ residential real estate owners

time tranches allocate principal and prepayments _______

sequentially by seniority

time tranches allocate default proportionally among all tranches

true

credit tranches allocate principal and prepayments _____

proportionally

credit tranches allocate default to the most _____ tranche and move ______

junior, upward

What happens to the duration of the MBS as the rate of prepayment increases?

duration decreases because you get more cash flows sooner

If you are a pension fund and are most worried about the duration of your investment contracting, in which time tranche should you invest?

the most junior tranche, because it is the least likely to have duration shortened with prepayment since they get paid last

People buy credit/ default tranches because they are cheaper, have a higher risk, which in turn have a higher yield

true