2013 CFA Level 1 - Book 5

BOOK 5
FIXED INCOME ,
DERIVATIVES, AND ALTERNATIVE
INVESTMENTS
-

Reading Assignments and Learning Outcome Statements
Study Session 15 - Fixed Income: Basic Concepts

........................................

.................................................

Study Session 16- Fixed Income: Analysis and Valuation

87
186

...........................................................................

191

Study Session 18- Alternative Investments

........................................................

278

............................................

309

............................................................................................................

312

.................................................................................................................

314

Self-Test - Derivatives and Alternative Investments
Formulas
Index

11

.................................................................

Self-Test - Fixed Income Investments
Study Session 17- Derivatives

....................................

3


SCHWESERNOTES™
2013
CPA
LEVEL

I
BOOK
5:
FIXED
INCOME,
DERIVATIVES, AND ALTERNATIVE INVESTMENTS
©20 12 Kaplan, Inc. All rights reserved.
Published in 2012 by Kaplan Schweser.
Printed in the United States of America.
ISBN: 978-1-4277-4265-0 1-4277-4265-0
PPN: 3200-2848
I

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was
distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation
of global copyright laws. Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: "CFA® and Chartered Financial Analyst® are trademarks owned
by CFA Institute. CFA Institute (formerly the Association for Investment Management and Research)
does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan
Schweser."
Certain materials contained within this text are the copyrighted property of CFA Institute. The following
is the copyright disclosure for these materials: "Copyright, 2012, CFA Institute. Reproduced and
republished from 2013 Learning Outcome Statements, Level I, II, and III questions from CFA® Program
Materials, CFA Institute Standards of Professional Conduct, and CFA Institute's Global Investment
Performance Standards with permission from CFA Institute. All Rights Reserved."
These materials may not be copied without written permission from the author. The unauthorized
duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.
Your assistance in pursuing potential violators of this law is greatly appreciated.
Disclaimer: The SchweserNotes should be used in conjunction with the original readings as set forth by

CFA Institute in their 2013 CFA Level I Study Guide. The information contained in these Notes covers

topics contained in the readings referenced by CFA Institute and is believed to be accurate. However,
their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success. The
authors of the referenced readings have not endorsed or sponsored these Notes.

Page 2

©2012 Kaplan, Inc.


READING ASSIGNMENTS AND
L EARNING OUTCOME STATEMENTS

The following material is a review ofthe Fixed Income, Derivatives, andAlternative
Investments principles designed to address the learning outcome statements setforth by
CPA Institute.
STUDY SESSION 15

Reading Assignments
CFA Program 2013 Curriculum, Volume 5 (CFA Institute,
2012)52. Features of Debt Securities
page
11
53.54. Risks
Associated
with
Investi
n
g

in
Bonds
page
25
page
ew ofnBond
page 4669
55. Overvi
Understandi
g YielSectors
d Spreadsand Instruments
Equity and Fixed Income,

STUDY SESSION 16

Reading Assignments CFA Program 2013 Curriculum, Volume 5 (CFA Institute,
2012)56. Introduction to the Valuation of Debt Securities
page
87
page
101
57.58. Yield
Measures,to theSpotMeasurement
Rates, and Forward
RatesRate Risk
Introduction
of
Interest
page
134

page 157
59. Fundamentals of Credit Analysis
Equity and Fixed Income,

STUDY SESSION 17

Reading Assignments
CFA Program 2013 Curriculum, Volume 6
(CFA60.Institute,
2012)
page
Deri
v
ati
v
e
Markets
and
Instruments
191
page 213
61.62. Forward
MarketsandandContracts
Contracts
197
page
Futures
Markets
page
226

63.64. Swap
OptioMarkets
n MarketsandandContracts
Contracts
page
254
page 268
65. Risk Management Applications of Option Strategies

Derivatives and Alternative Investments,

STUDY SESSION 18

Reading Assignments
CFA Program 2013 Curriculum, Volume 6
(CFA66.Institute,
2012)
Introductionin Commodities
to Alternative Investments
page 278
67. Investing
page
303

Derivatives and Alternative Investments,

©20 12 Kaplan, Inc.

Page 3

Book 5 - Fixed Income, Derivatives, and Alternative Investments
Reading Assignments and Learning Outcome Statements

LEARNING OUTCOME STATEMENTS (LOS )

The CPA 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 betterfit with the
flow ofthe review.
STUDY SESSION 15

The topical coverage corresponds with the following CPA Institute assigned reading:

ofdate should be able to:
The
candi
a. expl
a
i
n
the
purposes
of
a
bond'
s
i
n
denture
and

describe
affi
r
mati
v
e
and
negati
v
e
covenants.the(page
11)features of a bond, the various coupon rate structures, and the
b. describe
basic
structure
of floating-rate
securities.
(pageclean12)price. (page 14)
n
e
accrued
i
n
terest,
ful
l
price,
and
c.d. defi
ain thecommon

provisions
for redemption
anda bond
retirement
of bonds.the(page
14)
e. expl
identify
options
embedded
in
issue,
explain
importance
ofbondholder.
embedded(page
options,16) and identify whether an option benefits the issuer or the
describe
methods
used by (i.institutional
investors
in repurchase
the bond market
to finance
the
purchase
of
a
security
e

.
,
margi
n
buyi
n
g
and
agreements).
(page 17)

52. Features

Debt Securities

f.

The topical coverage corresponds with the following CPA Institute assigned reading:

53. Risks Associated with Investing in Bonds

The
candidate
should
be able to:with investing in bonds. (page 25)
a
i
n
the
ri

s
ks
associated
a.b. expl
identify
the
rel
a
tions
among
a
bond'
s
coupon
rate,
the
yield
required
by
the
market,
and
the(pagebond'27)s price relative to par value (i.e., discount, premium, or
equal
to
par).
ain howratea bond
maturity,
coupon, embedded options and yield level affect
c. iexpl

t
s
interest
risk.
(page
27)
d. bond
identifyandthetherelprice
ationofofthetheembedded
price of a callable
bond(page
to the29)price of an option-free
call
option.
a
i
n
the
interest
rate
risk
of
a
fl
o
ati
n
g-rate
security
and

why
its
price
may
e. expl
dicalculate
ffer fromandparinterpret
value. (page
29) and dollar duration of a bond. (page 30)
the
duration
describrisk.
e yiel(page
d-curve32)risk and explain why duration does not account for yield­
g. curve
ain34)the disadvantages of a callable or prepayable security to an investor.
h. expl
(page
identify
the
factors
that
affect
the
reinvestment
risk
of
a
security
and

explain
why
prepayable
amortizingsecurities.
securities(page
expose34)investors to greater reinvestment
risk
than
nonamortizing
types of risk
creditandriskwhyanditthemightmeaning
and roletoofinvestors
credit ratings.
(page
35)
k. describe
expl
a
i
n
liquidity
be
important
even
if
they
expect to hold a security to the maturity date. (page 36)
f.

1.

)·

Page 4

©2012 Kaplan, Inc.


Book 5 Fixed Income, Derivatives, and Alternative Investments
Reading Assignments and Learning Outcome Statements
-

describe
thecurrency.
exchange(pagerate37)risk an investor faces when a bond makes payments in
a
forei
g
n
explaaiinn how
inflatiyield
on risk.volatil(pageity affects
37) the price of a bond with an embedded option
m.n. expl
and
how(pagechanges
in volatility affect the value of a callable bond and a purable
bond.
37)
o. describe sovereign risk and types of event risk. (page 38)

Overview
of
Bond
Sectors
and
Instruments
The
candidatefeatures,
shouldcredit
be ableriskto:characteristics, and distribution methods for
describe
a. government
securities.
(page
46)
b. describe
typesbonds,
of securities
issued
byprotection
the U.S. Department
of thedistinguish
Treasury
(e.between
g., bills,theon-the-run
notes,
and
infl
a
tion

securities),
and
andTreasury
off-the-run
Treasury
securities.and(page
47) between
describe strihowps stripped
securities
are
created
di
s
tinguish
c. coupon
and and
principal
strips. c(page
49) issued by U.S. federal agencies.
d. describe
the
types
characteristi
s
of
securities
(page
49)
theowtypes
and characteristi

cfors ofeachmortgage-backed
securities and explain
e. describe
the
cash
fl
and
prepayment
risk
type.
(page
50)
expl
ain52)the motivation for creating a collateralized mortgage obligation.
(page
thebetween
types oftax-backed
securities issued
by municipalities
in(page
the United
States and
g. describe
distinguish
debt
and
revenue
bonds.
53)
the

characteristi
c
s
and
moti
v
ation
for
the
various
types
of
debt
issued
h. bydescribe
corporations
(inclpaper,
udingnegotiable
corporateCDs,
bonds,andmedium-term
notes, structured
notes,
commercial
bankers
acceptances).
(page e55)
defi
n
e
an

asset-backed
security,
describe
the
rol
e
of
a
special
purpose
vehicl
in issue
an asset-backed
security'security,
s transaction,
state thethe types
motivatiofoexternal
n for a corporation
toenhancements
an asset-backed
and
describe
credit
for
asset-backed
securities.
(page
59)
describe
col

l
aterali
z
ed
debt
obligations.
(page
60)
mechanithesmsprimary
availableandforsecondary
placing bonds
market61)and
k. describe
distinguishthebetween
marketsin theforprimary
bonds. (page
Understanding
Yield Spreads
The
candi
d
ate
should
berateablepolicy
to: tools available to a central bank. (page 69)
identify thea yieldinterest
a.b. describe
curve
andofthethevarious
shapes ofoftheinyield

curve.
(pagedescribe
70) the
a
i
n
the
basic
theories
term
structure
terest
rates
and
c. expl
implications
of
each
theory
for
the
shape
of
the
yi
e
l
d
curve.
(page

71)
ne a spot
rate.
(pageyield
73) spread measures. (page 74)
e.d. defi
calculate
and
compare
describe credi(page
t spreads
and relationships between credit spreads and economic
conditions.
75)
describe
howliembedded
options
affectaffects
yieldthespreads.
(page 76)of a bond relative to
h.g. expl
a
i
n
how
q
uidity
and
issue-size
yield

spread
other similar securities. (page 76)
I.

54.

The topical coverage corresponds with the following CFA Institute assigned reading:

f.

1.

J·

55.

The topical coverage corresponds with the following CFA Institute assigned reading:

f.

©20 1 2 Kaplan, Inc.

Page 5


Book 5 Fixed Income, Derivatives, and Alternative Investments
Reading Assignments and Learning Outcome Statements
-

1.

)·

calculate thesecurity.
after-tax(page
yield77)of a taxable security and the tax-equivalent yield of a
tax-exempt
defi
n
e
and
explain
its
importance
to
funded
investors
who
borrow
short
term. (page 78)
LIBOR

STUDY SESSION 16

The topical coverage corresponds with the following CFA Institute assigned reading:

56. The candidate should be able to:
aibnesteps
inofthebonds

bondforvalwhiuation
process. (page
87) cash flows is difficult.
descri
types
c
h
estimating
the
expected
b.a. expl
(page
87)
c.d. calculate
the thevaluepriceof aofbond
(coupon
andifzero-coupon).
(pagechanges
88) and as the
expl
a
i
n
how
a
bond
changes
the
discount
rate

bond
its maturi
tyofdate.a bond(pagegiven
91) a change in its discount rate.
calculateapproaches
the
change
i
n
value
e. (page
92)and demonstrate the use of the arbitrage-free valuation approach and
expl
a
i
n
descri
b
e
how
a
dealer
can
generate
an
arbitrage
profi
t
i
f

a
bond
i
s
mispriced.
(page 94)
57. The candidate should be able to:
describe theandsources
of traditional
return fromyield
investimeasures
ng in a forbond.fixed-rate
(page 10bonds
1) and
b.a. expl
calculate
interpret
aiinn thei
rreilimitations
and
assumptions.
(pagein calculating
101) yield to maturity
c. expl
a
the
n
vestment
assumption
implicit

describeandtheinterpret
factorsthethatbond
affectequivalent
reinvestment
risk.
(page
1 08) bond and the
d. and
calculate
yield
of
an
annual-pay
annual-paytheyield
of a semiannual-pay
bond.Treasury
(page 110)
e. the
describe
cal
c
ulation
of
the
theoretical
spot rate curve and calculate
val
u
e
of

a
bond
using
spot
rates.
(page
111)
f. expl
ain these
nominal,
zero-vol
aoption
tility, and
option-adjusted
spreads and the relations
among
spreads
and
cost.
(page
115)
a
i
n
a
forward
rate
and
cal
c

ul
a
te
spot
rates
from
forward
rates,
forward
rates
g. expl
from spot rates, and the value of a bond using forward rates. (page 118)
58. The candidate should be able to:
ntheguishduration/convexi
between the fullty approach
valuationforapproach
(theinterest
scenariorateanalysis
approach)
a. disti
and
measuring
risk,
and
expl
ibnethetheadvantage
of usingcharacteri
the fulslticsvaluation
approach.callable,
(page 134)prepayable,

b. and
descriaputable
price
volatility
for
option-free,
bondsconvexi
whentinterest
ratesvchange.
(page
136)their relation to bond
describeandpositive
y
and
negati
e
convexi
t
y,
and
c. price
yield. (page 136)
Introduction to the Valuation of Debt Securities

f.

The topical coverage corresponds with thefollowing CFA Institute assigned reading:

Yield Measures, Spot Rates, and Forward Rates

The topical coverage corresponds with the following CFA Institute assigned reading:
Introduction to the Measurement of Interest Rate Risk

Page 6

©2012 Kaplan, Inc.


Book 5 Fixed Income, Derivatives, and Alternative Investments
Reading Assignments and Learning Outcome Statements
-

d.
e.
f.
g.
h.

calculate
and interpret
thel increase
effectiveandduration
offora bond,
gichanges
ven information
about
how
the
bond'
s

price
wil
decrease
gi
v
en
i
n
interest
rates.
(page
139)
calculate durati
the approximate
percentage
priceinchange
for a bond,
given the bond's
effective
o
n
and
a
specifi
e
d
change
yield.
(page
141)

distinguish
among
the
alternati
v
e
defi
n
itions
of
duration
and
explain
why
effective
durationoptions.
is the most
appropriate
measure of interest rate risk for bonds
with
embedded
(page
142)
calculate
the duration
of atheportfolio,
givenoftheportfolio
durationduration.
of the bonds
comprising

the
portfolio,
and
explain
limitations
(page
144)
describe
the convexity
measure
of a bondandandconvexi
estimatety and
a bond'
s percentage
price
change,
given
the
bond'
s
duration
a
speci
fied change in
(page 145)
idistinguish
nterest rates.between
modifi
eadbasis
convexi

tyt and
effective
convexi
titsy. relationship
(page 147) to
calculate
the
price
val
u
e
of
poi
n
(PVBP),
and
explai
n
(pageimpact
147)of yield volatility on the interest rate risk of a bond.
k. duration.
describe
the
(page 148)
1.

)·

The topical coverage corresponds with the following CFA Institute assigned reading:

59. Fundamentals of Credit Analysis

The
candidatecredishould
beandablcredi
e to:t-related risks affecting corporate bonds. (page 157)
a.b. describe
t
ri
s
k
descri
b
e
seniority
ranki
n
gs
of
corporate
debt
and
expl
a
i
n
the
potential
violation
of the prioritybetween

of claimscorporate
in a bankruptcy
proceeding.
(page
158)
issuer
credit
rati
n
gs
and
issue
credit ratings and
c. distinguish
descri
b
e
the
rati
n
g
agency
practice
of
"notching".
(page
159)
explaaiinn theriskscomponents
in relying onofratitraditional
ngs fromcredit

creditanalysis.
rating agencies.
(page 160)
d.e. expl
(page
161)
calculate
and
interpret
fi
n
ancial
ratios
used
in
credi
t
analysis.
(page
163)
evaluatekeythefincredit
quali
tsyforofthea corporate
bondthe issuer
and(page
a bond167)of that issuer,
g. given
anci
a
l

rati
o
issuer
and
industry.
factors
thatimpact
influenceof spread
the levelchanges.
and vol(page
atility169)
of yield spreads. (page 169)
h. describe
calculate
the
return
explain special
consideratidebt
ons when
credi172)
t of high yield,
sovereign,
and municipal
issuersevalanduating
issues.the(page
f.

1.

)·

STUDY SESSION 17

The topical coverage corresponds with the following CFA Institute assigned reading:

60. The candidate should be able to:
ne a derivatives.
derivative and(pagedistinguish
between exchange-traded and over-the­
a. defi
counter
191)
contrast
forwardcontracts,
commitments
andcontracts,
contingentoptions
claims.(calls(pageand191)
c.b. defi
n
e
forward
futures
puts), and swaps
and
compare
their
basi
c
characteristics.

(page
192)
purposes
of
and
controversies
related
to
deri
v
ati
v
e
markets.
(page
192)
d.e. describe
explain
arbitrage and(pagethe 193)
role it plays in determining prices and promoting
market efficiency.
Derivative Markets and Instruments

©20 1 2 Kaplan, Inc.

Page 7


Book 5 Fixed Income, Derivatives, and Alternative Investments
Reading Assignments and Learning Outcome Statements

-

The topical coverage corresponds with the following CPA Institute assigned reading:

61. The candidate should
andbeContracts
abl
e
to:
ain delcontract.
ivery/settl(page
ement197)and default risk for both long and short positions in
a. aexplforward
bation
e the procedures
for settling
aaffect
forwardcredicontract
at expiration,
and how
b. descri
termi
n
prior
to
expiration
can
t
ri
s

k.
(page
198)
nguish
between
a dealer
andequityan end
user contracts
of a forwardandcontract.
(page 199)on
d.c. disti
descri
b
e
the
characteristi
c
s
of
forward
forward
contracts
zero-coupon
and
coupon
bonds.
(page
200)
beandthe Euribor.
characteristics

of202)the Eurodollar time deposit market, and define
e. descri
LIBOR
(page
forward
rate
agreements
(FRAs)
and
cal
c
ul
a
te
the
gain/loss
on
a
FRA.
f. describe
(page 203)and interpret the payoff of a FRA and explain each of the component
g. terms
calculate
payoff formula.
203)forward contracts. (page 205)
cs of(page
currency
h. describeof thethe characteristi
62. The candidate should
and Contracts

be ablecsto:of futures contracts. (page 213)
the
characteristi
a.b. describe
compare
contracts
andin forward
contracts.
(pageand213)margin in the futures
c. markets,
disti
nguishfutures
between
margin
the
securities
markets
andsettlement
explain theinrolefutures
of initrading.
tial margin,
maintenance
margin, variation
margin,
and
(page
214)
d. descri
b
e

price
limits
and
the
process
of
marki
n
g
to
market,
and
cal
c
ul
a
te
and
ithenterpret
theprice.
margi(page
n balance,
given the previous day's balance and the change in
futures
216)
how a futures contract can be terminated at or prior to expiration.
e. describe
(page
218)
describe thebill,characteristi

s of the folbond,
lowinstock
g typesindex,
of futures
contracts.(page 219)
f. Treasury
Eurodollar,cTreasury
and currency.
Forward Markets

The topical coverage corresponds with the following CPA Institute assigned reading:

Futures Markets

The topical coverage corresponds with thefollowing CPA Institute assigned reading:

63. The
Optioncandidate should
and Contracts
be abloptions.
e to: (page 226)
call
and
put
a.b. describe
distinguitheshconcept
betweenofEuropean
andofAmerican
options.
(page 227)

moneyness
an
option.
(page
228)
c.d. define
compare
exchange-traded
options
and
over-the-counter
options.
(page
229)
theinterest
typesrateof options
inwithtermsforward
of therateunderlying
instruments.
(page230)
229)
e. identify
compare
options
agreements
(FRAs).
(page
interest
rate caps,option
floors,payoffs

and collars.
(pageain231)
calculate
and
interpret
and
expl
how
i
n
terest
rate
options
h.g. define
differnefrom
othervalue
typesandof time
options.value,(pageand233)
defi
intrinsic
explainof their
relationship.
(page 234)
determine
the
minimum
and
maximum
values
European

options
and
canandoptions.
(pagethe237)lowest prices of European and American calls and
k. Ameri
calculate
interpret
puts based on the rules for minimum values and lower bounds. (page 238)
Markets

f.

1.

j.

Page 8

©2012 Kaplan, Inc.


Book 5 Fixed Income, Derivatives, and Alternative Investments
Reading Assignments and Learning Outcome Statements
-

expl
ain how(page
option242)prices are affected by the exercise price and the time to
expiration.
m. explain

put-call
parity
for
European
options,
and
explain
how
put-cal
l
parity
is
atedain tohowarbicashtragefloandws onthetheconstruction
ofassetsynthetic
options.l pari
(pagety 243)
n. relexpl
underlying
affect
put-cal
and the
lower
bounds
of
option
prices.
(page
245)
o. determine
an option'stheprice.directional

(page 246)effect ofan interest rate change or volatility change on

I.

The topical coverage corresponds with the following CFA Institute assigned reading:

64. The candidate should be able to:
a. describe
the
characteristi
c
s
of
swap
contracts
and
expl
a
i
n
how
swaps
are
terminated.calculate,
(page 255)
nterpretswaps.
the payments
b. describe,
interest rate swaps, and
and iequity

(page 256)of currency swaps, plain vanilla
65. The candidate should be able to:
determine underl
the valyuinge atprice
expiration,
the profit,andmaximum
profioft,themaxistrategi
mum eloss,
a. breakeven
at
expiration,
payoff
graph
sfor
ofinvestors
buyingusing
and selthese
ling strategi
calls andes. puts
and
determine
the
potential
outcomes
(page
268)
b. breakeven
determine underl
the valyuinge atprice
expiratatiexpiration,

on, profit, maximum
profi
t, maximum
loss,
and
payoff
graph
of
a
covered
calapplication
l strategyofandeacha protective
put
strategy,
and
explain
the
ri
s
k
management
strategy. (page 272)
Swap Markets and Contracts

The topical coverage corresponds with the following CFA Institute assigned reading:

Risk Management Applications of Option Strategies

STUDY SESSION 18

The topical coverage corresponds with the following CFA Institute assigned reading:

66. The candidate should be able to:
compare categories
alternativeofinalvestments
wiinvestments.
th traditional(pageinvestments.
(page 278)
b.c.a. describe
t
ernati
v
e
278)
describe
potential
benefits
of alternative investments in the context of portfolio
management.
(page
279)
hedge
funds, private
equity,asrealapplicable,
estate, commodities,
and other
d. describe
alternati
v
e

i
n
vestments,
incl
u
ding,
strategies,
sub-categories,
potential
benefi
t
s
and
ri
s
ks,
fee
structures,
and
due
diligence.
(page
280)
e. describe
issuesestate,in valuing,
and calculating
returns
on, hedge funds, private
equity,
real

and
commodities.
(page
280)
descri
b
e,
calculate,
and
i
n
terpret
management
and
i
n
centi
v
e
fees
and
net-of-fees
funds. (pageof alternati
292) ve investments. (page 294)
describetoriskhedge
management
g. returns
Introduction to Alternative Investments

f.

©20 12 Kaplan, Inc.

Page 9


Book 5 Fixed Income, Derivatives, and Alternative Investments
Reading Assignments and Learning Outcome Statements
-

The topical coverage corresponds with the following CPA Institute assigned reading:

67. The
Investing
inateCommodities
candi
d
should
be
able
to:
ain the relationship
between (page
spot prices
and expected future prices in terms
a. ofexplcontango
and
backwardation.
303)
bone thea portfolio

sources ofof return
andan allocation
risk for a commodity
investment
and the
b. descri
effect
adding
to
commodities.
(page
304)
ain why (page
a commodity
c. expl
investment.
305) index strategy is generally considered an active

Page 10

©2012 Kaplan, Inc.


The following is a review of the Analysis of Fixed Income Investments principles designed to address the
learning outcome statements set forth by CFA Institute. This topic is also covered in:

FEATURES OF DEBT SECURITIES
Study Session 15

EXAM FOCUS

xeda giincome
securities,of years
historical
lythen
, wererepay
promises
tooanpayamount
a streamat ofthesemiannual
payments
forFicontract
vbetween
en number
and
the
l
maturi
t
y
date.
The
the borrower
andthatthethelender
(the
indenture)
canofrealcontracts
ly be desithat
gnedareto have
any
payment

stream
or
pattern
parti
e
s
agree
to.
Types
frequently have specific names, and there is no shortage of those (for you to learn) here.used
You
specialof these)
attention
to how/when
how the periodic
payments
ared (calls,
determined
(fixed,ng
flfunds,
oatishould
ng,amortization,
andpayvariants
and
to
the
principal
is
repai
puts,

sinki
andwhen
prepayments).
These
features
all affectsecurities
the valueandofcompare
the securities
and
will
come
up
again
you
learn
how
to
value
these
their
risks, both at Level I and Level II.
LOS 52.a: Explain the purposes of a bond's indenture and describe affirmative
and negative covenants.
CFA® Program Curriculum, Volume 5, page 294

The contract
that specifiis called
es all thethe rights and obligations
of the issuerdefiandnes thetheowners
of a

fixed
income
security
The
indenture
obligations
of and restrictions
on theandborrower
and These
forms thecontract
basis provisions
for all futurearetransactions
between
the
bondholder
the
issuer.
known as
and include(actions
both that the borrower (prohibitions
on
the
borrower)
and
promises to perform) sections.
include
restrictionsnegative
on assetplesales
(thecollateral
company(thecan'company

t sell assetscan't
that
have
been
pledged
as
collateral),
dge
of
claimadditional
that theborrowings
same assets (the
backcompany
several debtcan'issues
simultaneously),
and unless
restrictions
onfinancial
t
borrow
additional
money
certain
conditions are met).
include
the For
maintenance
ofthecertain
financial
ratios

andtothemaintain
timely
payment
of
principal
and
interest.
example,
borrower
mi
g
ht
promise
theis notcompany'
s
current
ratio
at
a
value
of
two
or
higher.
If
thi
s
val
u
e

of
the
current
ratio
maintained, then the bonds could be considered to be in (technical) default.
bond indenture.

covenants
affirmative

negative covenants

covenants

Negative covenants

Affirmative covenants

©20 12 Kaplan, Inc.

Page 1 1


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52

-

Features of Debt Securities

LOS 52.b: Describe the basic features of a bond, the various coupon rate
structures, and the structure of floating-rate securities.
CPA® Program Curriculum, Volume 5, page 295

A6% (option-free)
bond
iyears
s the from
simplesttodaycase.in Consider
a Treasury
bondThisthatbondhas ias a
and
fi
v
e
the
amount
of
$1,000.
promise
. Treasury)
of thefrom$1,0today.
00
(i.e., $60)
each yearbyforthefive years(theandU.toSrepay
the $1,to0pay
00 fi6%ve years
Wi
t
h

Treasury
bonds
and
almost
all
U.
S
.
corporate
bonds,
the
annual
interest
is
paid
in(onetwoevery
semiannual
installments.
Therefore,
this bondof wi$1,ll0make
nineparcoupon
payments
si
x
months)
of
$30
and
a
fi

n
al
payment
30
(the
value
pl
us thethe final
coupon
payment)
at
the
end
of
five
years.
This
stream
of
payments
is
fixed
when
bonds are issued and does not change over the life of the bond.
Note
that aseachan semiannual
coupon
is one-half
thewhicoupon
rate (whichcalled

is alwtheays
expressed
annual
rate)
ti
m
es
the
par
value,
c
h
i
s
sometimes
or payment of $4,An0008%every
Treasury
note wiandth aafacefinalvalpayment
ue of $100,
000 wi000ll make
amaturity.
coupon
six months
of $104,
at
AotherU.Scurrenci
. Treasuryes bond
is The
denominated (of course) in U.S.of adollars.
BondsbycanthebeMexican

issued in
as
well.
bond
issued
government
kely be Mexican pesos. Bonds can be issued that promise to make
payments in wianyll licurrency.
straight

coupon

matures
issuer

par value

foce

value

maturity value.

currency denomination

Coupon Rate Structures: Zero-Coupon Bonds, Step-Up Notes, Deferred­
Coupon Bonds

arenterestbondsresults
thatfrom

do notthepayfactperiodic
interest. They
payaretheinitially
par value
atsoldmaturi
t
y
and
the
i
that
zero-coupon
bonds
at a pricewe below
(i.e., theywitharenosoldexpliat caitsignifi
Sometimes
will calparl debtvaluesecurities
interestcantpayments
at a specified rate. The increase
may take placehave
one orcoupon
more rates
timesthatduringincrease
the lifover
e oftithemeissue.
carry
coupons,accrue,
but atthea initial
couponrate,payments
aredeferral

deferredperiodfor
some
period.
The
coupon
payments
compound
over
the
andpassed,
are paidthese
as a lump
sum
atregulthearendcoupon
of thatinterest
period.forAfter
the initial
deferment
period
has
bonds
pay
the
rest
of
the
l
i
f
e

of
the
issue
(to maturity).
Zero-coupon bonds

discount to par value) .
pure discount

securities.

Step-up notes

Deferred-coupon bonds

Page 12

©2012 Kaplan, Inc.


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52 - Features of Debt Securities

Floating-Rate Securities

svary
c r based
i s areonbonds
forewhich
the rate

coupon
interest
payments
over
the life
ofinterest
the security
a
specifi
d
i
n
terest
or
i
n
dex.
For
example,
if
market
rateshave
are movi
ng up,thatthearecoupons
on straight(normally
floaters willeveryrise3,as6,wellor. 12In months)
essence,
these
bonds
coupons

reset
periodically
based on prevailing market interest rates.
The
mostchcommon
procedure
for setting
the, thecoupon
rates
on U.floSating-rate
securities
is
one
whi
starts
wi
t
h
a
(e.
g
.
rate
on
certain
.
Treasury
securities
or the London
Interbank

Offeredrate.RateThe[LIBOR])
and
thenn mayaddsalsoor vary
subtracts
atimstated
to
or
from
that
reference
quoted
margi
over
e
according
to a scheduleThus,
that istostated
ascoupon
the formula:
find thein thenewindenture.
coupon rate,Theyouschedul
woulde isuseoftenthe referred
followintog
new coupon rate reference rate quoted margin
Just
th a fixed-coupon bond, a semiannual coupon payment will be one-half the
(annualas wi) coupon
is aratefloating-rate
securityinterest
with a coupon

formulaandthatviactuall
yA
icoupon
ncreasesformul
the coupon
when
a
reference
rate
decreases,
c
e
versa.
a such as coupon rate = 12% - reference rate accomplishes this.
Some
fl
o
ating-rate
securities
have
coupon
formulas
based
on
infl
a
tion
and
are
referred

bond with
a coupon
of 3%security.
annual change in
theto asConsumer Price Index is anAexampl
e of such
an inflformula
ation-linked
The
parties toratethebybondplacing
contract
canandlimloitwertheilimits
r exposure
tocoupon
extremerate.fluctuations
in
thelimit,reference
upper
on
the
The
upper
whi
c
h
is
called
a
puts
a

maximum
on
the
interest
rate
paid
by
the
borrower/
issuer. Thepayments
lower limit,
callbyed thea lender/security
puts a minimum
onWhen
the periodic
coupon
interest
received
owner.
both
limits
are present
simultaneously, the combination is called a
Consider
a
fl
o
ati
n
g-rate

security
(fl
o
ater)
with
a
coupon
rate
at
issuance
of
5%,
a
7%
cap, theandborrower
a 3% floor.wilIfl paythe (lender
coupon will
ratereceive)
(referenceonlyrate7%plusfortheas long
margin)
risescoupon
aboverate,
7%,
as
the
accordingwilto lthepayformula,
remains
attheor above
7%.rate,If according
the coupontoratethe falls

belowremains
3%, the
borrower
3%
for
as
long
as
coupon
formula,
at or below 3%.
Floating-rate e

u

it e

reference rate

margin

coupon formula.

±

=

rate.

An inverse floater

+

inflation-indexed bonds.

cap,

floor,

collar.

©20 12 Kaplan, Inc.

Page 1 3


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52

-

Features of Debt Securities

LOS 52.c: Define accrued interest, full price, and clean price.
CFA® Program Curriculum, Volume 5, page 301

When
bondthetrades
between
coupon

dates,
thetheselldate
er is ofentitltheedsale.to recei
vies any
interest
earned afrom
previous
coupon
date
through
This
known
as
and isofantheamount
that
is payable
byof thethe next
buyercoupon
(new owner)
of and
the will
bond.
The
new
owner
bond
wi
l
l
recei

v
e
all
payment
then
recover
any
accrued
i
n
terest
pai
d
on
the
date
of
purchase.
The
accrued
i
n
terest
i
s
calculated as the fraction of the coupon period that has passed times the coupon.
InthethebondUnited
States,
the
convention

i
s
for
the
bond
buyer
to
pay
any
accrued
interest
to
sel(theler. The amountplusthatanytheaccrued
buyer pays
to theIn selthelerUnited
is the agreed-upon
price
of
the
bond
interest.
States,
bonds
trade
withethright
the next
coupon
attached,is said
whictoh beis termed
A bond

traded
without
to
the
next
coupon
trading
The
total
amount
paid,
including
known as the
of the bond. The full
price = cleanaccrued
price interest,
accruedis interest.
If the issuertheof thebondbondwillistrade
in default
., has notinterest,
made periodic
coupon
payments),
without(i.eaccrued
and it is obligatory
said to be tradingflat.
accrued interest

clean price)

cum coupon.
ex-coupon.

+

full (or dirty) price

LOS 52.d: Explain the provisions for redemption and retirement of bonds.
CFA® Program Curriculum, Volume 5, page 301

The
redemptiontheprovisions
circumstances
principal forwillabebondrepaid.refer to how, when, and under what
Coupon
Treasury
bonds
andatmostwhichcorporate
bonds
arepar or face value isthat
is, they
pay
onl
y
interest
until
maturity,
ti
m
e

the
enti
r
e
repaid.
This
repayment
structure
is referred
toprincipal
as a be repaidor through a series Alternati
vely,over
the
bond
terms
may
specify
that
the
of
payments
time
or
al
l
at
once
prior
to
maturity,

at
the
option
of
ei
t
her
the
bondholder
or
the
issuer
(putable and callable bonds).
make
periodic
payments
over
the
life
of
the
bond.
A conventional
mortgageconsists
is anofexampl
e of an interest
amortizingpayment
loan; theandpayments
are
allof aequal,

and
each
payment
the
periodic
the
repayment
portion
of
the
original
principal.
For
a
fully
amortizing
loan,
the
fi
n
al
(l
e
vel)
payment
automobileat maturity
loan). retires the last remaining principal on the loan (e.g., a typical
options
giThese
ve theoptions

issuer/borrower
theinrimortgages
ght to accelerate
the principal
repayment
on
a
loan.
are
present
and
other
amortizing
loans.
Amorti
z
i
n
g
loans
require
a
series
of
equal
payments
that
cover
the
periodic

i
n
terest
and
reduce
the
outstanding
principal
each
ti
m
e
a
payment
is
made.
When
a
person
gets
a
home
or anIfautomobile
any thetime,
in wholemortgage
or in part.
the borrowerloan,sellsshetheoften
homehasor theauto,rightshetois prepay
requiredittoat pay
nonamortizing;

bullet bond

Amortizing securities

interest and principal

Prepayment

Page 14

bullet maturity.

©2012 Kaplan, Inc.


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52 - Features of Debt Securities

loan off in full. Thesecurity
signifiicsance
oftherea prepayment
option
to an investor
in acashmortgage
or
mortgage-backed
that
i
s

additional
uncertainty
about
the
fl
o
ws
to
be received compared to a security that does not permit prepayment.
Call
provisions
give
the
issuer
the
ri
g
ht
(but
not
the
obligation)
to
retire
all
or
a
part
of
an issue prior

tobonds
maturity.
If thecallbonds
are called,thethebonds
bondholders
have
no choice
buttheyto
surrender
their
for
the
pri
c
e
because
qui
t
payi
n
g
interest
when
arecoupon
called.bonds
Callwifeatures
give the issuer
th lower-coupon
issues.the opportunity to replace higher-than-market
Typical

l
y,
there
is
a
period
of
years
after
issuance
during
whi
c
h
the
bonds
cannot
be
called.a This
is termed
the period
ofthe period (if any)because
thel protection
bondholderhas ispassed,
protected
from
call
over
this
period.

After
of
cal
the
bonds are referred to as
There mayly,bewhen
severala bond
call dates
specionfiedtheinfitherst indenture,
each
with athelowercall calpricel price.
Customari
is
called
permissible
call
date,
is
above
theoverpartime
value.accordi
If thenbonds
areschedule.
not calForled example,
entirely ora notcall called
at all,maythespecifY
call price
decl
i
nes

g
to
a
schedule
that
acall20-year
bond
can
be
call
e
d
after
fi
v
e
years
at
a
pri
c
e
of
110
(110%
of
par),
wi
t
h

the
price declining to 105 after ten years and 100 in the 15th year.
Nonrefundable
bondsThus,prohibit
themaycallbeofcallan aisblsuee butusinnotg therefundable.
proceeds from
a lothat
wer is
coupon bondhasissue.
a
bond
A
bond
absolute
priorother
to maturi
y. In contrast, a callable
but
bond protection
can be calledagaifornstanya callreason
than trefunding.
When
bondsbondsarearecalledsaidthrough
a call optionIf a orlowerthrough
theissue
provisions
oftoaprovide
sinkingthe
fund,
the

to
be
redeemed.
coupon
i
s
sol
d
funds to call the bonds, the bonds are said to be refunded.
Sinking
fund
provisions
provi
d
e
for
the
repayment
of
principal
through
a
series
of
payments
overmaythe requi
life ofrethethatissue.
For example,
a 20-miyllion
ear issue

wiprincipal
th a face amount
of
$300
million
the
issuer
reti
r
e
$20
of
the
every
year
beginning in the sixth year. This can be accomplished in one of two
or
The
issuer
may
deposit
the
required
cash
amount
annually
with
the
issue's trustee
whong wia selection

ll then retimethod
re the such
applicable
proportion
of bondssele(1/15
inthethis
example)
by
usi
as
a
l
o
ttery.
The
bonds
cted
by
trustee are typically retired
at
par.
The
issuerred may
purchase
bonds
with aandtotaldeliparvervalue
equal
to
thetrusteeamount
that

i
s
to
be
reti
i
n
that
year
i
n
the
market
them
to
the
who will retire them.
Ifis thethe less
bondsexpensive
are tradialntgernative.
below parIf thevalue,bondsdelivery
of
bonds
purchased
i
n
the
open
market
ares thetrading

above thewaypartovalue,
deliveri
ng
cash
to
the
trustee
to
reti
r
e
the
bonds
at
par
i
less
expensive
satisfY
the
sinking fund requirement.
call protection

currently callable.

noncallable
nonrefundable

ways-cash

delivery:
•

Cash payment.

•

Delivery ofsecurities.

©20 12 Kaplan, Inc.

Page 1 5


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52

-

Features of Debt Securities

Anthanaccelerated
sinking
fundspecifi
provision
allosinki
ws theng issuer
the choice ofAsretianringexample,
more
the

amount
of
bonds
e
d
in
the
fund
requirement.
thechooseissuerto retire
may beuprequired
to
redeem
$5
million
par
val
u
e
of
bonds
each
year
but
may
to $10 million par value of the issue.
Regular and Special Redemption Prices

When
bonds

are asredeemed
under the callandprovisions
specifi
eared inreferred
the bondto asindenture,
these
are
known
regular
redemptions,
the
call
prices
regular
redemption
prices.
However,of awhen
bondssalearemandated
redeemedbytogovernment
comply withauthority,
a sinkingthe
fund
provisi
o
n
or
because
property
redemption
prices

(typically
par
value)
are
referred
to
as
special
redemption
prices.
Asset
sales
maybybeantitrust
forced byauthori
a regultieastoryor through
authoritya governmental
(e.g., the forcedunit'divesti
thtureofofeminent
an operating
divi
s
ion
s
ri
g
domain).
Exampl
essalofe sales
forced through
theforgovernment'

selright
ofutilieminent
domain
woul
d
be
a
forced
of
privately
held
land
erection
of
e
ctric
t
y
lines
or
for
construction of a freeway.
LOS 52.e: Identify common options embedded in a bond issue, explain the
importance of embedded options, and identify whether an option benefits the
issuer or the bondholder.
CPA® Program Curriculum, Volume 5, page 302

The
fol
l

o
wing
are
exampl
e
s
of
embedded
i
n
the
sense
that
they
are
anoptions
integralare part
of the bond
contract
andtheareissuer
not aofseparate
securiandty.some
Someareembedded
exercisable
at
the
option
of
the
bond,

exercisable
at the option of the purchaser of the bond.
Security
ownerty options.
In thegranted
following
cases,
the option
embedded
ingithevesfiadditional
xed­
income
securi
is
an
option
to
the
security
holder
(lender)
and
value to the security, compared to an otherwise-identical straight (option-free) security.
embedded options,

grants shares
the holder
of
a
bond

the
right
to
convert
the
bond
i
n
to
a
1. Afixed number of common
ofis thesimilar
issuer.butThisallowschoice/option
hasthevaluebondforintothe a
bondhol
d
er.
An
exchange
option
conversion
of
security other than the common stock of the issuer.
2. specified pricegipriveobondholders
the
ri
g
ht
to
sell

(put)
the
bond
to
the
issuer
at
a
rortoclose
maturito tpar.y. TheIf interest
put priceratesis generally
parand/or
ifthethebonds were
original
l
y
issued
at
have
ri
s
en
creditworthiness
of thetheissuer
has deteriorated
so that
the market
priceoption
of suchandbonds
has

fall
e
n
below
par,
bondholder
may
choose
to
exerci
s
e
the
put
require the issuer to redeem the bonds at the put price.
3. couponsetratea minimum
on theeachcoupon
ratebasedforona floating-rate
bond,usually
a bonda short-term
with a
that
changes
period
a
reference
rate,
rate such as LIBOR or the T-bill rate.
conversion option

Put provisions

Floors

Page 16

©2012 Kaplan, Inc.


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52 - Features of Debt Securities

Security
issuerof the
options.
Inincome
these security.
cases, theSecurities
embeddedwhere
optiontheisissuer
exercisabl
e atwhether
the option
ofto theexercise
issuer
fi
x
ed
chooses
the

embedded
option
wi
l
l
be
priced
less
(or
wi
t
h
a
hi
g
her
coupon)
than
otherwise identical securities that do not contain such an option.
1. maturity. The detai
give lthes ofbond
ht to redeem
a callissuer
featurethearerigcovered
later in(paythisoff)topithec reviissueew.prior to
2. by mortgages or carareloans.included
in many amortizing
securities,
such as thosethebacked
A

prepayment
option
gi
v
es
the
borrower/issuer
riLoans
ght to
prepay
the
loan
bal
a
nce
pri
o
r
to
maturi
t
y,
i
n
whole
or
i
n
part,
wi

t
hout
penal
t
y.
may bein prepaid
of a mortgage
drop
interest forratesa vari
or theetysalofereasons,
of a homesuchprioras theto itsrefinancing
loan maturity
date. due to a
are proportion
embedded options
heldthan
by theis required
issuer thatbyalthelow
thesinkiissuer
to
(annually)
reti
r
e
a
l
a
rger
of
the

issue
ng fund provision, up to a specified limit.
setrate
a maximum
on theeachcoupon
ratebasedfor ona floaating-rate
bond,usually
a bonda wishort-term
th a
coupon
that
changes
period
reference
rate,
rate such as LIBOR or the T-hill rate.
Callprovisions

Prepayment options

3. Accelerated sinkingfundprovisions

4.

Caps

Professor's Note: Caps andfloors do not need to be "exercised" by the issuer or
bondholder. They are considered embedded options because a cap is equivalent
to a series of interest rate call options and a floor is equivalent to a series of
interest rate put options. This will be explained further in our topic review of

Option Markets and Contracts in the Study Session covering derivatives.

Toto calsummarize,
the(2)follanoaccel
wingerated
embedded
options
favor the issuer/borrower:
(1)option,
the rightand
l
the
issue,
si
n
king
fund
provision,
a
prepayment
(4)borrower/issuer.
a cap on the floating
coupon
rate
that
limi
t
s
the
amount

of
interest
payable
by
the
theseumoptions
higher option-free
market yieldbonds.
s since
bondholders willBonds
requirewitha premi
relativewitoll tend
otherwito have
se identical
The
ng embedded
options
favorinterest
the payment to theconversion
provisions,
(2) aafolflputolorowioption.
that
guarantees
a
minimum
bondholder,
andbe lower
The
market
yields

on
bonds
with
these
options
will
tend
to
than
attractiotherwise
ve. identical option-free bonds since bondholders will find these options
(3)

bondholders: (1)

(3)

LOS 52.f: Describe methods used by institutional investors in the bond market
to finance the purchase of a security (i.e., margin buying and repurchase
agreements).
CFA® Program Curriculum, Volume 5, page 308

Marginthebuying
involves
borrowing
fundscollateral
from aforbroker
or a bankloan.to purchase
securities
where

securities
themsel
v
es
are
the
the
margin
The
margi
n
amount
(percentage
of
the
bonds'
val
u
e)
i
s
regulated
by
the
Federal
Reserve
i
n
the
United States, under the Securities and Exchange Act of

1934.

©20 12 Kaplan, Inc.

Page 17


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52

-

Features of Debt Securities

(repo) toagreement
is anat arrangement
bya whi
cheand (higher)
institutionprice.sellsThea security
wiA repurchase
th a commitment
buy
it
back
a
l
a
ter
date
at

specifi
is
greater
than
the
sell
i
ng
price
and
accounts
for
the
interest
charged
by
the buyer,
who
is, intheeffect, lendingwhifunds
to theannuali
sellezr.edThepercentage
interest ratedifference
impliedbetween
by the
two
prices
i
s
called
c

h
i
s
the
theagreement
two prices.
A
repurchase
agreement
for
one
day
is
called
an
and
an
a wouldThe
customarilycovering
less thana thelongerrateperiod
a bankisorcalled
brokerage
chargeinterest
on a cost
margiofn aloan. is
Most bond-dealer
financing
is achieagreements
ved througharerepurchase
agreements

rather than
through
margin
loans.
Repurchase
not
regulated
by
the
Federal
Reserve,
and
the
collateral
position
of
the
lender/buyer
in
a
repo
is
better
i
n
the
event
of
bankruptcy
ofn totheselldealiteback

r, sinceat thethe price
securityspecifi
is owned
by therepurchase
lender. The
lender hasratheronly
the
obligati
o
e
d
i
n
the
agreement,
than simply having a claim against the assets of the dealer for the margin loan amount.
repurchase price

repo rate,

overnight repo,

term repo.

Page 18

©2012 Kaplan, Inc.

repo

Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52 - Features of Debt Securities

KEY CONCEPTS

ALOS
bond'ors buyer
indenture
contains the obligations, rights, and any options available to the
issuer
of a bond.
Covenants
arevethecovenants
specific specify
conditionsactionsof thethatobligation:
Affi
r
mati
the
borrower/issuer
must
perform.
Negative covenants prohibit certain actions by the borrower/issuer.
LOS have the following features:
Bonds
Maturity-the
term of the loan
agreement.
Par

value
(
f
ace
value)-the
principal
amount
of
the
fi
x
ed
income
security
that
the
bond
issuerrate-the
promisesratetoused
pay theto determine
bondholdersthe over
the liinterest
fe of thetobond.
Coupon
periodic
be paid on onthethe
principal
amount.
Interest
can

be
pai
d
annually
or
semiannual
l
y
,
depending
terms. Coupon rates may be fixed or variable.
TypesOption-free
of coupon (straight)
rate structures:
bonds pay periodic interest and repay the par value at
maturi
t
y.
Zero-coupon
bonds
pay
no
expli
c
it
periodic
interest
and
are
sold

at
a
discount
to
par
value.
Step-up notes have a coupon rate that increases over time according to a specified
schedule.
Deferred-coupon
bonds
initialof thely make
no coupon
payments
(they(compound)
are deferredinterest
for a
period
of
time).
At
the
end
deferral
period,
the
accrued
s flpaid,
makehasregul
ar coupon
payments

unti
l maturity.
Ai(usually
oatingandLIBOR)
(varitheabonds
ble)andrateathen
bond
a
coupon
formula
that
i
s
based
on
a
reference
rate
quoted
margin.coupon
A caprateis athemaxibondholder
mum coupon
rate
theve onissuerany
must
pay,
and
a
fl
o

or
i
s
a
minimum
will
recei
coupon date.
LOS
Accrued
interestto aisbond
the interest
a bond buyer
seller. earned since the last coupon payment date and is paid by
Clean price is the quoted price of the bond without accrued interest.
Full price refers to the quoted price plus any accrued interest.
52.a

•

•

52.b

•

•

•

•

•

•

•

•

52.c

©20 12 Kaplan, Inc.

Page 1 9


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52

-

Features of Debt Securities

LOS
52.d
BondAmortizing
retirementsecurities
(payoff) make
provisions:

periodic
payments
that
include
both
interest
and
principal
paymentsoccurs.
so that the entire principal is paid off with the last payment
unless
prepayment
Ato prepayment
option
is
contained
in
some
amortizing
debt
and
allows
the
borrower
pay offfundprincipal
at anyrequire
time prior
topartmaturity,
in whole
or reti

in part.
Sinking
provisions
that
a
of
a
bond
issue
be
red at specified
dates,
typical
l
y
annuall
y
.
Cal
l
provi
s
ions
enable
the
borrower
(issuer)
to
buy
back

the
bonds
from
the
iCalnvestors
(redeem
them) at abonds
call price(s)
specifi
eprior
d in theto maturity,
bond indenture.
l
abl
e
but
nonrefundable
can
be
call
e
d
their rate.
redemption cannot be funded by the issuance of bonds with a lowerbutcoupon
LOS
52.e options that benefit the issuer reduce the bond's value (increase the yield) to
Embedded
a bondCallpurchaser.
Examples are:
provisions.

Accelerated
sinking
fund
provisions.
Caps (maximum interest rates) on floating-rate bonds.
Embedded
optionspurchaser.
that benefit
bondholders
increase the bond's value (decrease the
yield)Conversion
to a bond
Examples
are:
optisocommon
ns (the option
of bondholders to convert their bonds into shares of
thePut bond
i
s
suer'
stock).
options (theprice).
option of bondholders to return their bonds to the issuer at a
predetermined
Floors (minimum interest rates) on floating-rate bonds.
LOS
52.
f
Institutions

can
financeprice,secondary
market
bond
purchases
by) or,margi
n buying
(borrowi
ng
some
of
the
purchase
using
the
securi
t
i
e
s
as
coll
a
teral
more
commonl
y
,
by
repurchase

(repo)to agreements,
ananarrangement
inhigher
whichprice
an institution
sells date
a security
with
a
promise
buy
it
back
at
agreed-upon
at
a
specified
i
n
the
future.
•

•

•
•

•

•

•
•

•

•

•

Page 20

©2012 Kaplan, Inc.


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52 - Features of Debt Securities

CONCEPT CHECKERS

s indenture:
1. AA. bond'
contains
i
t
s
covenants.
the same

C.B. isrelates
onlyastoaitsdebenture.
interest and principal payments.
2. Asemiannual
bond haslya. parWhatvaluisetheof $5,dollar000amount
and a coupon
rate of 8. 5 %coupon
payablepayment?
of
the
semiannual
A.B. $238.
$212.353.0.
$425.00.
3. would
From theaddperspective
of the bondholder,
which
of the following pairs of options
value
to
a
straight
(option-free)
bond?
A.B. Put
Calloption
optionandandconversion
conversionoption.
option.

C. Prepayment option and put option.
4. Aby10-year
bond
pays
no
interest
for
three
years,
then
pays
$229.
2
5,
foll
o
wed
payments
ofs bond
$35 semiannually
for seven years and an additional $1,000 at
maturi
t
y.
Thi
i
s
a:
A.B. step-up
bond.

bond.bond.
C. zero-coupon
deferred-coupon
a $11 andmilJuly
lion semiannual-pay,
floating-raterateissue
where theLIBOR,
rate isandreset
5. Consider
ontheJanuary
1
each
year.
The
reference
is
6-month
stated
margin
is
+
1.25%.
If
6-month
LIBOR
i
s
6.5%
on
July

1,
what
wil
l
semiannual
coupon be on this issue?
A.theB. next
$38,
7
50.
$65,
0
00.
$77,500.
of thehavefollcapsowinandg statements
is
with regard to floating-rate
6. Which
issues
that
fl
o
ors?
A. AiSSUer.
cap is an advantage to the bondholder, while a floor is an advantage to the
B. AiSSUer.
floor is an advantage to the bondholder, while a cap is an advantage to the
C. Aa diflsoadvantage
or is an advantage
to

both
the
issuer
and
the
bondholder,
whi
l
e
a
cap
i
s
to both the issuer and the bondholder.
investorcoupon
paid adates,
full priandceaccrued
of $1,059.interest
04 eachwasfor$23.10054bonds.
TheWhat
purchase
was
7. Anbetween
per
bond.
is
each
bond'
s
clean

price?
A.B. $1,$1,035.
000.050.0.
$1,082.58.
c.

c.

most accurate

c.

©20 12 Kaplan, Inc.

Page 2 1


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52

-

Features of Debt Securities

of the following statements is
with regard to a call
8. Which
provision?
A.B. AA callable
call provision

will
benefit
the
issuer
i
n
times
of
declining
interest
rates.
bond will trade at a higher price than an identical noncallable
bond.
C. Anoncallable
nonrefundabl
e
bond
provides
more
protection
to
the
bondholder
than
a
bond.
ofy callable
the follobond?
wing
describes the maximum price for a

9. Which
currentl
A.B. The
Its parcallvalue.
C. The presentprice.value of its par value.
and
Consider
$1,are000,cal0lable
00 parandvalue,
10-year,
6.n5g%fundcoupon
bondsTheissuedmarket
on January
1,sim2005.
The
bonds
there
i
s
a
sinki
provision.
rate
for
bonds is currently 5.7%. The main points of the prospectus are summarized as follows:ilar
Call dates and prices:
2005
through 1,2009:
After January
2010:103.102.

Additional information:
The
bonds
are
non-refundable.
The
sinkingamount
fund provision
requires
that theundercompany
redeem
$100,
000 fund
of the
principal
each
year.
Bonds
called
the
terms
of
the
sinking
provision
will
be
redeemed
at
par.

The credit rating of the bonds is currently the same as at issuance.
10. A.Usingtheonlybondsthedopreceding
information,
Gould should conclude that:
not
have
call
protection.
issuedtheatbonds
and currentl
B.C. githevenbonds
currentwererates,
will likelyy trade
be calatleda premium.
and new bonds issued.
11. Which
of the following statements about the sinking fund provisions for these
bonds
is
A. Anof theinvestor
would
benefit from having his bonds called under the provision
sinking
fund.
B. Anunderinvestor
will recei
vethea premium
if the bond is redeemed prior to maturity
the
provisi

o
n
of
sinki
n
g
fund.
C. The bonds do not have an accelerated sinking fund provision.
12. AnA. investor
buying
bonds
on
margin:
interestbyongovernment
a loan. regulation of margin lending.
B.C. actually
imust
s notpayrestricted
lends the bonds to a bank or brokerage house.
most accurate

most accurately

Use the following information to answer Questions 10

•
•

•
•

•

most accurate?

Page 22

©2012 Kaplan, Inc.

11.


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52 - Features of Debt Securities

13. byWhich
of the following is
a provision for the early retirement of debt
the
issuer?
A.B. AA conversion
option.
C. A call
sinkingoption.
fund.
is loan.
14. A.A mortgage
a
col
l

ateralized
B.C. characterized
subject to earlbyy retirement.
highly predictable cash flows.
least likely

least likely:

©20 12 Kaplan, Inc.

Page 23


Study Session 1 5
Cross-Reference to CFA Institute Assigned Reading #52 - Features of Debt Securities

ANSWERS - CONCEPT CHECKERS

1.

A

An indenture is the contract between the company and its bondholders and contains the
bond's covenants.

2.

A

The annual interest is 8.5% of the $5,000 par value, or $425. Each semiannual payment

is one-half of that, or $212.50.

3.

B

A put option and a conversion option have positive value to the bondholder. The other
options favor the issuer and result in a lower value than a straight bond.

4.

C

This pattern describes a deferred-coupon bond. The first payment of $229.25 is the
value of the accrued coupon payments for the first three years.

5.

A

The coupon rate is 6.5 + 1 .25 7.75. The semiannual coupon payment equals
(0.5)(0.0775)($1 ,000,000) $38,750.
=

=

6.

B

A cap is a maximum on the coupon rate and is advantageous to the issuer. A floor is a
minimum on the coupon rate and is, therefore, advantageous to the bondholder.

7.

B

The full price includes accrued interest, while the clean price does not. Therefore, the
clean price is 1 ,059.04 - 23.54 $ 1 ,035.50.
=

Page 24

8.

A

A call provision gives the bond issuer the right to call the bond at a price specified in the
bond indenture. A bond issuer may want to call a bond if interest rates have decreased so
that borrowing costs can be decreased by replacing the bond with a lower coupon issue.

9.

B

Whenever the price of the bond increases above the strike price stipulated on the call
option, it will be optimal for the issuer to call the bond. So theoretically, the price of a
currently callable bond should never rise above its call price.

10. A

The bonds are callable in 2005, indicating that there is no period of call protection.
We have no information about the pricing of the bonds at issuance. The company may
not refond the bonds (i.e., they cannot call the bonds with the proceeds of a new debt
offering at the currently lower market yield) .

11. C

The sinking fund provision does not provide for an acceleration of the sinking fund
redemptions. With rates currently below the coupon rate, the bonds will be trading at a
premium to par value. Thus, a sinking fund call at par would not benefit a bondholder.

12. A

Margin loans require the payment of interest, and the rate is typically higher than
funding costs when repurchase agreements are used.

13. A

A conversion option allows bondholders to exchange their bonds for common stock. The
option is held by the boldholder, not the issuer.

14. C

A mortgage can typically be retired early in whole or in part (a prepayment option), and
this makes the cash flows difficult to predict with any accuracy.

©2012 Kaplan, Inc.