sample_ans6on1 - Answers to Sample Questions in Purple...

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Unformatted text preview: Answers to Sample Questions in Purple Book: Lecture Topics 6-12 Lecture 6: 1. First of all, let’s ignore the fact that your grandmother may not make it through the next ten years and assume she will be healthy enough to take the trip. By entering a contract whose cost is exactly equal the expected interest payments on the MBSs, she takes on considerable prepayment risk. If rates go up and no prepayments occur, she is fine because the trip payment contract and the MBS cash flows will exactly mirror each other. But if rates fall, the Ginnies will prepay and your grandmother will find that she has a lot of cash on hand that she can only invest at a low interest rate. The interest on her new investment will not be great enough to keep up with the trip payments. She will have to find some other source of funding to pay for the trip if the Ginnies prepay. She may want to get a cheaper trip or split her investment across Ginnies and a higher yielding (albeit riskier) investment. 2. This bond has about 10 years until maturity and it is paying a 6% coupon. Because the call price is par, Xerox could effectively pay an interest rate of 6% to bondholders to get rid of the debt. If Xerox issued ten year debt today, it would pay 6.2% to bondholders. So calling the debt would mean swapping out cheap financing for debt that is 20 bp more expensive. Xerox would not call the bond. 3. This topic is not actually covered in class. If you are curious, a put option on a bond should be exercised whenever the market interest rate is higher than the coupon on the bond (assuming the put option has a strike price of par.) Since this bond has 15 years remaining until maturity (it was issued 15 years ago as a 30-year bond), the market rate that is relevant is the rate on a 15 year bond, not a 30 year bond. The market rate is 14% and the coupon on this bond is only 12%, so the bond is worth less than par. The bondholder should exercise the put and hand the bond over to the company in exchange for par value in cash. 4. If you buy an interest-only strip, you are making a bet that rates on mortgages don’t change. If rates rise (here from 15 to 18%), then the investment loses value the way any Treasury bond loses value when rates go up 300 bp. (If the modified duration on the mortgages is 10 years, which is plausible, then the price drop is 30%! Even at MD=5 years, the drop is very noticeable.) If rates fall to 10%, you can expect all the mortgages to prepay (maybe, you will get lucky and have a few burnouts) and the interest cash flow will go to zero (or very close if not everyone prepays). 5. If you owned the PO strip, you would also lose money like any bondholder when rates rise. If rates fell, you would get a lot of principal back. Once you did, you would have to reinvest the money at a low interest rate. Not as painful as being an IO investor, but still unpleasant if you had locked in longer term liabilities at 15% (say in 4 year CDs). If you are lucky, some people won’t prepay and you will earn a higher than market return on those few people who fail to exercise their option. earn a higher than market return on those few people who fail to exercise their option....
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This note was uploaded on 07/17/2008 for the course FIN 726 taught by Professor Helwege during the Spring '04 term at Ohio State.

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sample_ans6on1 - Answers to Sample Questions in Purple...

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