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© CFA Institute For candidate use only Not for distribution FIXED INCOME AND DERIVATIVES CFAđ Program Curriculum 2020 ã LEVEL I ã VOLUME â CFA Institute For candidate use only Not for distribution © 2019, 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, 2008, 2007, 2006 by CFA Institute All rights reserved This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself It does not cover the individual selections herein that first appeared elsewhere Permission to reprint these has been obtained by CFA Institute for this edition only Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service If legal advice or other expert assistance is required, the services of a competent professional should be sought All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only ISBN 978-1-946442-80-2 (paper) ISBN 978-1-950157-04-4 (ebk) 10 © CFA Institute For candidate use only Not for distribution CONTENTS How to Use the CFA Program Curriculum Background on the CBOK Organization of the Curriculum Features of the Curriculum Designing Your Personal Study Program Feedback vii vii viii viii x xi Fixed Income Study Session 14 Fixed Income (1) Reading 42 Fixed-Income Securities: Defining Elements Introduction Overview of a Fixed-Income Security Basic Features of a Bond Yield Measures Legal, Regulatory, and Tax Considerations Bond Indenture Legal and Regulatory Considerations Tax Considerations Structure of a Bond’s Cash Flows Principal Repayment Structures Coupon Payment Structures Bonds with Contingency Provisions Callable Bonds Putable Bonds Convertible Bonds Summary Practice Problems Solutions 5 12 12 13 21 24 26 26 30 37 37 39 40 43 46 50 Reading 43 Fixed-Income Markets: Issuance, Trading, and Funding Introduction Overview of Global Fixed-Income Markets Classification of Fixed-Income Markets Fixed- Income Indexes Investors in Fixed-Income Securities Primary and Secondary Bond Markets Primary Bond Markets Secondary Bond Markets Sovereign Bonds Characteristics of Sovereign Bonds Credit Quality of Sovereign Bonds Types of Sovereign Bonds 55 55 56 56 63 64 65 66 70 73 73 74 75 indicates an optional segment ii © CFA Institute For candidate use only Not for distribution Contents Non-Sovereign Government, Quasi-Government, and Supranational Bonds 77 Non- Sovereign Bonds 77 Quasi- Government Bonds 77 Supranational Bonds 78 Corporate Debt 79 Bank Loans and Syndicated Loans 79 Commercial Paper 80 Corporate Notes and Bonds 83 Structured Financial Instruments 87 Capital Protected Instruments 88 Yield Enhancement Instruments 88 Participation Instruments 88 Leveraged Instruments 89 Short-Term Funding Alternatives Available to Banks 90 Retail Deposits 90 Short- Term Wholesale Funds 91 Repurchase and Reverse Repurchase Agreements 92 Summary 96 Practice Problems 99 Solutions 103 Reading 44 Introduction to Fixed-Income Valuation Introduction Bond Prices and the Time Value of Money Bond Pricing with a Market Discount Rate Yield-to-Maturity Relationships between the Bond Price and Bond Characteristics Pricing Bonds with Spot Rates Prices and Yields: Conventions for Quotes and Calculations Flat Price, Accrued Interest, and the Full Price Matrix Pricing Annual Yields for Varying Compounding Periods in the Year Yield Measures for Fixed-Rate Bonds Yield Measures for Floating-Rate Notes Yield Measures for Money Market Instruments The Maturity Structure of Interest Rates Yield Spreads Yield Spreads over Benchmark Rates Yield Spreads over the Benchmark Yield Curve Summary Practice Problems Solutions 107 107 108 108 112 113 117 119 119 123 126 129 132 135 140 147 147 149 152 155 164 Reading 45 Introduction to Asset-Backed Securities Introduction Benefits of Securitization for Economies and Financial Markets How Securitization Works An Example of a Securitization Parties to a Securitization and Their Roles 179 179 180 181 182 183 indicates an optional segment Contents © CFA Institute For candidate use only Not for distribution iii Structure of a Securitization Key Role of the Special Purpose Entity Residential Mortgage Loans Maturity Interest Rate Determination Amortization Schedule Prepayment Options and Prepayment Penalties Rights of the Lender in a Foreclosure Residential Mortgage-Backed Securities Mortgage Pass-Through Securities Collateralized Mortgage Obligations Non-agency Residential Mortgage-Backed Securities Commercial Mortgage-Backed Securities Credit Risk CMBS Structure Non-Mortgage Asset-Backed Securities Auto Loan ABS Credit Card Receivable ABS Collateralized Debt Obligations CDO Structure An Example of a CDO Transaction Summary Practice Problems Solutions 185 187 190 191 191 192 192 193 194 195 201 208 208 209 209 213 213 216 217 217 218 220 224 229 Study Session 15 Fixed Income (2) 237 Reading 46 Understanding Fixed‑Income Risk and Return Introduction Sources of Return Interest Rate Risk on Fixed-Rate Bonds Macaulay, Modified, and Approximate Duration Effective Duration Key Rate Duration Properties of Bond Duration Duration of a Bond Portfolio Money Duration of a Bond and the Price Value of a Basis Point Bond Convexity Interest Rate Risk and the Investment Horizon Yield Volatility Investment Horizon, Macaulay Duration, and Interest Rate Risk Credit and Liquidity Risk Summary Practice Problems Solutions 239 240 240 247 248 255 259 259 265 267 269 277 278 279 284 285 289 294 indicates an optional segment iv Reading 47 © CFA Institute For candidate use only Not for distribution Contents Fundamentals of Credit Analysis Introduction Credit Risk Capital Structure, Seniority Ranking, and Recovery Rates Capital Structure Seniority Ranking Recovery Rates Ratings Agencies, Credit Ratings, and Their Role in the Debt Markets Credit Ratings Issuer vs Issue Ratings Risks in Relying on Agency Ratings Traditional Credit Analysis: Corporate Debt Securities Credit Analysis vs Equity Analysis: Similarities and Differences The Four Cs of Credit Analysis: A Useful Framework Credit Risk vs Return: Yields and Spreads Special Considerations of High-Yield, Sovereign, and Non-Sovereign Credit Analysis High Yield Sovereign Debt Non-Sovereign Government Debt Summary Practice Problems Solutions 301 302 302 305 305 305 307 311 312 313 315 320 320 321 338 Study Session 16 Derivatives 383 Reading 48 Derivative Markets and Instruments Introduction Derivatives: Definitions and Uses The Structure of Derivative Markets Exchange-Traded Derivatives Markets Over-the-Counter Derivatives Markets Types of Derivatives Forward Commitments Contingent Claims Hybrids Derivatives Underlyings The Purposes and Benefits of Derivatives Risk Allocation, Transfer, and Management Information Discovery Operational Advantages Market Efficiency Criticisms and Misuses of Derivatives Speculation and Gambling Destabilization and Systemic Risk Elementary Principles of Derivative Pricing Storage 385 385 386 389 390 391 394 394 406 418 419 422 423 424 425 425 426 426 427 429 429 347 347 355 359 361 365 375 Derivatives indicates an optional segment Contents Reading 49 © CFA Institute For candidate use only Not for distribution v Arbitrage Summary Practice Problems Solutions 430 435 438 445 Basics of Derivative Pricing and Valuation Introduction Fundamental Concepts of Derivative Pricing Basic Derivative Concepts Pricing the Underlying The Principle of Arbitrage The Concept of Pricing vs Valuation Pricing and Valuation of Forward Commitments Pricing and Valuation of Forward Contracts Pricing and Valuation of Futures Contracts Pricing and Valuation of Swap Contracts Pricing and Valuation of Options European Option Pricing Binomial Valuation of Options American Option Pricing Summary Practice Problems Solutions 455 456 456 456 458 462 468 469 469 476 478 481 482 496 500 503 505 511 Glossary G-1 indicates an optional segment © CFA Institute For candidate use only Not for distribution © CFA Institute For candidate use only Not for distribution How to Use the CFA Program Curriculum Congratulations on your decision to enter the Chartered Financial Analyst (CFA®) Program This exciting and rewarding program of study reflects your desire to become a serious investment professional You are embarking on a program noted for its high ethical standards and the breadth of knowledge, skills, and abilities (competencies) it develops Your commitment to the CFA Program should be educationally and professionally rewarding The credential you seek is respected around the world as a mark of accomplishment and dedication Each level of the program represents a distinct achievement in professional development Successful completion of the program is rewarded with membership in a prestigious global community of investment professionals CFA charterholders are dedicated to life-long learning and maintaining currency with the ever-changing dynamics of a challenging profession The CFA Program represents the first step toward a career-long commitment to professional education The CFA examination measures your mastery of the core knowledge, skills, and abilities required to succeed as an investment professional These core competencies are the basis for the Candidate Body of Knowledge (CBOK™) The CBOK consists of four components: ■■ A broad outline that lists the major topic areas covered in the CFA Program (https://www.cfainstitute.org/programs/cfa/curriculum/cbok); ■■ Topic area weights that indicate the relative exam weightings of the top-level topic areas (https://www.cfainstitute.org/programs/cfa/curriculum/overview); ■■ Learning outcome statements (LOS) that advise candidates about the specific knowledge, skills, and abilities they should acquire from readings covering a topic area (LOS are provided in candidate study sessions and at the beginning of each reading); and ■■ The CFA Program curriculum that candidates receive upon examination registration Therefore, the key to your success on the CFA examinations is studying and understanding the CBOK The following sections provide background on the CBOK, the organization of the curriculum, features of the curriculum, and tips for designing an effective personal study program BACKGROUND ON THE CBOK The CFA Program is grounded in the practice of the investment profession Beginning with the Global Body of Investment Knowledge (GBIK), CFA Institute performs a continuous practice analysis with investment professionals around the world to determine the competencies that are relevant to the profession Regional expert panels and targeted surveys are conducted annually to verify and reinforce the continuous feedback about the GBIK The practice analysis process ultimately defines the CBOK The © 2019 CFA Institute All rights reserved vii viii © CFA Institute For candidate use only Not for distribution How to Use the CFA Program Curriculum CBOK reflects the competencies that are generally accepted and applied by investment professionals These competencies are used in practice in a generalist context and are expected to be demonstrated by a recently qualified CFA charterholder The CFA Institute staff, in conjunction with the Education Advisory Committee and Curriculum Level Advisors, who consist of practicing CFA charterholders, designs the CFA Program curriculum in order to deliver the CBOK to candidates The examinations, also written by CFA charterholders, are designed to allow you to demonstrate your mastery of the CBOK as set forth in the CFA Program curriculum As you structure your personal study program, you should emphasize mastery of the CBOK and the practical application of that knowledge For more information on the practice analysis, CBOK, and development of the CFA Program curriculum, please visit www.cfainstitute.org ORGANIZATION OF THE CURRICULUM The Level I CFA Program curriculum is organized into 10 topic areas Each topic area begins with a brief statement of the material and the depth of knowledge expected It is then divided into one or more study sessions These study sessions—19 sessions in the Level I curriculum—should form the basic structure of your reading and preparation Each study session includes a statement of its structure and objective and is further divided into assigned readings An outline illustrating the organization of these 19 study sessions can be found at the front of each volume of the curriculum The readings are commissioned by CFA Institute and written by content experts, including investment professionals and university professors Each reading includes LOS and the core material to be studied, often a combination of text, exhibits, and in-text examples and questions A reading typically ends with practice problems followed by solutions to these problems to help you understand and master the material The LOS indicate what you should be able to accomplish after studying the material The LOS, the core material, and the practice problems are dependent on each other, with the core material and the practice problems providing context for understanding the scope of the LOS and enabling you to apply a principle or concept in a variety of scenarios The entire readings, including the practice problems at the end of the readings, are the basis for all examination questions and are selected or developed specifically to teach the knowledge, skills, and abilities reflected in the CBOK You should use the LOS to guide and focus your study because each examination question is based on one or more LOS and the core material and practice problems associated with the LOS As a candidate, you are responsible for the entirety of the required material in a study session We encourage you to review the information about the LOS on our website (www cfainstitute.org/programs/cfa/curriculum/study-sessions), including the descriptions of LOS “command words” on the candidate resources page at www.cfainstitute.org FEATURES OF THE CURRICULUM OPTIONAL SEGMENT Required vs Optional Segments You should read all of an assigned reading In some cases, though, we have reprinted an entire publication and marked certain parts of the reading as “optional.” The CFA examination is based only on the required segments, and the optional segments are included only when it is determined that they might ... 50 Reading 43 Fixed- ? ?Income Markets: Issuance, Trading, and Funding Introduction Overview of Global Fixed- ? ?Income Markets Classification of Fixed- ? ?Income Markets Fixed- Income Indexes ... Feedback vii vii viii viii x xi Fixed Income Study Session 14 Fixed Income (1) Reading 42 Fixed- ? ?Income Securities: Defining Elements Introduction Overview of a Fixed- ? ?Income Security Basic Features... Session 15 Fixed Income (2) 237 Reading 46 Understanding Fixed? ? ?Income Risk and Return Introduction Sources of Return Interest Rate Risk on Fixed- Rate Bonds Macaulay, Modified, and Approximate
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