FRM Exam 1 Definitions| Questions with Complete Solutions 100% Verified|
Latest Update Graded A+
deferred interest bond DIB will not pay cash interest for some # of years early in the life of
the bond
Payment in Kind (PIK) cash interest is accrued and paid semiannually until maturity or
redeemed
collateral trust bonds Bonds backed by financial assets. i.e stocks or note or bonds
Equipment Trust Certificates bonds secured with factory and equipment as collateral
debentures unsecured bonds
subordinated debenture bond has a claim at the bottom list of creditors if the issuer goes
into default
convertible debenture gives bondholder right to convert bond into common stock
Exchangeable Debentures convert bond into common stock other than corporation of the
issuer
guaranteed bonds backed by a company other than the issuer
fixed-price call provision allows the issuer to buy back all or part of its outstanding bonds at
a specified call price sometime before the bonds mature
,make-whole call provision the payment when the issuer calls a bond is determined by the
present value of the remaining payments discounted at a small spread over a maturity-matched
Treasury yield
sinking fund provision a provision in a bond contract that requires the issuer to retire a
portion of the bond issue each year
maintenance and replacement fund (M&R) same goal as sinking provision, maintain
credibility of property backing the fund
tender offers usually a means for retiring debt for most firms
Spread Duration Measures sensitivity of non-treasury issues to a change in their spread
above treasuries of the same maturity. approx % change in bonds price for 100 bps change in
credit spread
poison put forces the firm to buy securities back at some set price
businessman's risk bonds with rating at bottom rung of investment grate or top end of
speculative grade
event risk the risk that some major, unexpected event will occur that leads to a sudden and
substantial change in the value of an investment
fallen angels one time investment grade bonds
high-yield bonds bonds with low credit quality that offer a high yield to maturity, also called
junk bonds
,types of deferred coupon structures 1.deferred interest bonds
2.step up bonds
3.pay in kind bonds
issuer default rate # of issuers that default as a proportion of all issuers
dollar default rate estimates dollar amt of defaulted bonds compared to dollar amount of
corresponding population of bonds outstanding
Dollar Rolls MBS market maker is buying positions for one settle month and at the same
time selling same positions for another month
Monte Carlo Simulation A process which generates hundreds or thousands of probable
performance outcomes based on probability distributions for cost and schedule on individual
tasks. The outcomes are then used to generate a probability distribution for the project as a
whole. Very useful for mortgage securities
Option Adjusted Spread (OAS) spread that when added to all spot rates of all int paths will
make average PV of the paths equal to the actual observed market price plus accrued interest
binomial model only applicable for securities where decision to exercise call option is not
depended on how int rates evolve over time
Limitations to OAS 1.modeling risk with monte carlo sim
2.require adj to int rate paths
3.underlying assumption of a constant OAS over time of model
4.dependenvy of the underlying prepayment model
collar combo of protective put and covered call
, Down-and-out option A call option that ceases to exist if the underlying asset rises above a
certain price.
Down-and-In Option is a type of knock-in barrier option that only becomes viable when the
price of the underlying security falls to a specific price level
Up-and-out option A put option that ceases to exist if the underlying asset falls below a
certain price.
Up-and-in option a type of barrier option that can only be exercised when the price of the
underlying asset reaches a set barrier level
Shortcomings of risk metrics -May not scale over time
-Historical data may be meaningless
-Not designed to account for catastrophes
-VaR says nothing about losses in excess of VaR
-May not handle sudden illiquidity
Importance of communication for risk managers Need to assess risk and tell management so
they can determine which risks to take on
Ways firms can fail to account for risks -Firm may ignore known risk
-Somebody in firm may know about risk, but it's not captured by models
-Realization of a truly unknown risk
Ways risk can be mismeasured -Wrong distribution
-Historical sample may not apply
Latest Update Graded A+
deferred interest bond DIB will not pay cash interest for some # of years early in the life of
the bond
Payment in Kind (PIK) cash interest is accrued and paid semiannually until maturity or
redeemed
collateral trust bonds Bonds backed by financial assets. i.e stocks or note or bonds
Equipment Trust Certificates bonds secured with factory and equipment as collateral
debentures unsecured bonds
subordinated debenture bond has a claim at the bottom list of creditors if the issuer goes
into default
convertible debenture gives bondholder right to convert bond into common stock
Exchangeable Debentures convert bond into common stock other than corporation of the
issuer
guaranteed bonds backed by a company other than the issuer
fixed-price call provision allows the issuer to buy back all or part of its outstanding bonds at
a specified call price sometime before the bonds mature
,make-whole call provision the payment when the issuer calls a bond is determined by the
present value of the remaining payments discounted at a small spread over a maturity-matched
Treasury yield
sinking fund provision a provision in a bond contract that requires the issuer to retire a
portion of the bond issue each year
maintenance and replacement fund (M&R) same goal as sinking provision, maintain
credibility of property backing the fund
tender offers usually a means for retiring debt for most firms
Spread Duration Measures sensitivity of non-treasury issues to a change in their spread
above treasuries of the same maturity. approx % change in bonds price for 100 bps change in
credit spread
poison put forces the firm to buy securities back at some set price
businessman's risk bonds with rating at bottom rung of investment grate or top end of
speculative grade
event risk the risk that some major, unexpected event will occur that leads to a sudden and
substantial change in the value of an investment
fallen angels one time investment grade bonds
high-yield bonds bonds with low credit quality that offer a high yield to maturity, also called
junk bonds
,types of deferred coupon structures 1.deferred interest bonds
2.step up bonds
3.pay in kind bonds
issuer default rate # of issuers that default as a proportion of all issuers
dollar default rate estimates dollar amt of defaulted bonds compared to dollar amount of
corresponding population of bonds outstanding
Dollar Rolls MBS market maker is buying positions for one settle month and at the same
time selling same positions for another month
Monte Carlo Simulation A process which generates hundreds or thousands of probable
performance outcomes based on probability distributions for cost and schedule on individual
tasks. The outcomes are then used to generate a probability distribution for the project as a
whole. Very useful for mortgage securities
Option Adjusted Spread (OAS) spread that when added to all spot rates of all int paths will
make average PV of the paths equal to the actual observed market price plus accrued interest
binomial model only applicable for securities where decision to exercise call option is not
depended on how int rates evolve over time
Limitations to OAS 1.modeling risk with monte carlo sim
2.require adj to int rate paths
3.underlying assumption of a constant OAS over time of model
4.dependenvy of the underlying prepayment model
collar combo of protective put and covered call
, Down-and-out option A call option that ceases to exist if the underlying asset rises above a
certain price.
Down-and-In Option is a type of knock-in barrier option that only becomes viable when the
price of the underlying security falls to a specific price level
Up-and-out option A put option that ceases to exist if the underlying asset falls below a
certain price.
Up-and-in option a type of barrier option that can only be exercised when the price of the
underlying asset reaches a set barrier level
Shortcomings of risk metrics -May not scale over time
-Historical data may be meaningless
-Not designed to account for catastrophes
-VaR says nothing about losses in excess of VaR
-May not handle sudden illiquidity
Importance of communication for risk managers Need to assess risk and tell management so
they can determine which risks to take on
Ways firms can fail to account for risks -Firm may ignore known risk
-Somebody in firm may know about risk, but it's not captured by models
-Realization of a truly unknown risk
Ways risk can be mismeasured -Wrong distribution
-Historical sample may not apply
