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Questions and Answers of Corporate Finance

Give two reasons why a CMO tranche is a path-dependent cash flow security.
In the October 26, 1992, prospectus summary of the Staples 5% convertible subordinated debentures due 1999, the offering stated: “Convertible into Common Stock at a conversion price of $45 per
Answer the below questions.a. Suppose that a convertible bond has a conversion ratio of 20 and a delta of 0.70. For a price change of $0.125 for the stock price per share, what is the approximate
Why would you expect that a distressed convertible would have a delta of zero?
Suppose that the price of the underlying stock for aconvertible bond is considerably higher than theconversion price. What would expect that convertiblebond’s delta to be?
The following quotes are from Mihir Bhattacharya, “Convertible Securities and Their Valuation,” Chapter 51 in Frank J. Fabozzi (ed.), The Handbook of Fixed Income Securities: Sixth Edition (New
Why is a volatility trading strategy considered to be a non-directional strategy?
What is the difference between a busted convertible and a distressed convertible?
What is a cash flow arbitrage strategy involving convertible bonds?
What is the difference between a soft put and a hard put?
Upon exercise of the conversion option for a convertible bond, all issuers must exchange shares of stock for the bond. Explain whether you agree or disagree.
This excerpt is taken from an article titled “Caywood Looks for Convertibles,” which appeared in the January 13, 1992, issue of BondWeek, p. 7:Caywood Christian Capital Management will invest new
Explain the limitation of using premium over straight value as a measure of the downside risk of a convertible bond.
This excerpt comes from an article titled “Bartlett Likes Convertibles” in the October 7, 1991, issue of BondWeek, p. 7:“Bartlett & Co. is selectively looking for opportunities in
Consider a convertible bond as follows:par value = $1,000; coupon rate = 9.5%market price of convertible bond = $1,000conversion ratio = 37.383estimated straight value of bond = $510yield to maturity
A Merrill Lynch note structure called a liquid yield option note (LYON) is a zero-coupon instrument that is convertible into the common stock of the issuer. The conversion ratio is fixed for the
When using the percentage change in the credit spread as a measure of the credit spread change, what assumption is being made?
A portfolio manager currently has a portfolio consisting solely of investment-grade corporate bonds with an analytically computed duration of 6.6. The portfolio manager wants to sell 20% of the
Assuming the data in the following table for corporate bonds, compute the average hedge ratio (duration multiplier) at the average spread level for the three credit ratings (M1, M2, and M3):
Assuming the data in the following table for corporate bonds, compute the theoretical hedge ratio at the average spread level for the three credit ratings (X, Y, and Z):
Using the correlations for the corporate bonds shown in Exhibit 21-3, calculate the duration multiplier for the three credit ratings shown in the exhibit.Exhibit 21-3 Industry Portfolio Spread
Answer the below questions.(a) If the correlation between changes in Treasury rates and changes in the credit spread is zero, what is the duration multiplier?(b) If during a time period the
What does the empirical evidence suggest about the behavior of corporate credit spreads concerning whether credit spread changes should be measured on an absolute versus relative basis?
What is meant by spread duration and contribution to spread duration?
When all cash flows are assumed to be discounted by a single yield, why is there no difference between the duration (sensitivity to yield), interest-rate duration (sensitivity to rates), and spread
Assume the following for corporate bond A: spread duration = 5, credit spread = 100 basis points, and weight in the portfolio = 6%.Answer the below questions.(a) What is bond A’s duration times
Why is the duration-times-spread approach superior to the spread duration approach in estimating exposure to changes in corporate credit spreads?
Answer the below questions.(a) Corporate bond prices have interest-rate exposure and equity exposure. Why?(b) What type of corporate bond is more likely to have greater equity exposure,
What are the different approaches used to estimate the duration of high-yield corporate bonds?
(a) What is meant by the empirical duration of a corporate bond?(b) How is the empirical duration of a corporate bond estimated?
Answer the below questions.(a) What is the difference between a positive and negative covenant?(b) What is the purpose of the analysis of covenants in assessing the credit risk of an issuer?
Answer the below questions.(a) What are corporate governance ratings?(b) Are corporate governance ratings reported to the investing public?(c) What factors are considered by services that assign
Explain what a credit analyst should do in preparation for an analysis of the financial statements.
Answer the below questions.(a) What is the purpose of an interest coverage ratio?(b) What does an interest coverage ratio of 1.8 × mean?(c) Why are interest coverage ratios typically computed on a
Answer the below questions.(a) What is the purpose of a leverage ratio?(b) What measures are used in a leverage ratio for total capitalization?(c) What is the margin of safety measure?
Why do analysts investigate the bank lines of credit that a corporation has?
Answer each of the below questions.(a) Explain the meaning of funds from operation.(b) Explain the meaning of operating cash flow.(c) Explain the meaning of free operating cash flow.(d) Explain the
In the analysis of net assets, what factors should be considered?
Answer the below questions.(a) What is meant by working capital?(b) Why is an analysis of working capital important?
Why do analysts of high-yield corporate bonds feel that the analysis should be viewed from an equity analyst’s perspective?
Answer the below questions.(a) What is a maintenance test?(b) What is a debt incurrence test and when does it come into play?
Some credit analysts place less emphasis on collateral compared to covenants and business risk. Explain why.
Why do credit analysts begin with an analysis of the industry in assessing the business risk of a corporate issuer?
What is the purpose of a credit analyst investigating the market structure of an industry (e.g., unregulated monopoly, oligopoly, etc.)?
What should be the focus of an analyst with respect to the regulation of an industry?
In analyzing the labor situation in an industry in which a corporate issue operates, what should the credit analyst examine?
The underlying economic theory regarding many corporate governance issues is the principal-agency relationship between the senior managers and the shareholders of corporations. Explain this
With respect to corporate governance, what are the mechanisms that can mitigate the likelihood that management will act in its own self-interest?
Why is credit risk modeling more difficult than interest-rate modeling?
How does the Jarrow-Turnbull-Lando model differ from the basic Jarrow-Turnbull model?
Answer the below questions.(a) How is an event defined in the Poisson process?(b) What is meant by the intensity parameter in the Poisson process?
(a) What is the meaning of the default intensity parameter in a reduced-form model?(b) What are the various ways that the default intensity parameter can be modeled in a reduced-form model?
What is meant by default correlation?
What is the drawback of the default correlation measure and what alternative measure is used in measuring portfolio credit risk?
What would be a suitable metric to assess credit risk on a relative basis when making a relative value decision?
What is the motivation for the development of incomplete information credit risk models.
Why is the calibration of a credit risk model to the market important in fixed income trading?
A corporate bond portfolio manager was overhead asking:“Why do I need a credit risk model. I can get information about the probability of default from credit ratings?” How would you respond to
What is a common feature of all structural models?
Give two interpretations of the value of a bond from an option’s perspective.
Explain how the Black-Scholes-Merton model has been extended to allow for multiple bond issues in a corporation’s debt structure.
Explain how the Black-Scholes-Merton model has been extended to overcome the assumption that default can only occur at maturity.
How can structural models be used by bond portfolio managers?
How does the treatment of default in structural models and reduced-form models differ?
How do the Jarrow-Turnbull and Duffie-Singleton reduced-form models differ?
Why might the investment objective of a portfolio manager of a life insurance company be different from that of a mutual fund manager?
The investment objective of the Threadneedle bond fund is “To outperform the benchmark by 3% per annum (gross of fees) over an 18-24 month period” What type of fund is this?
Answer the below questions.(a) What is meant by systematic risk factors?(b) What is the difference between term structure and non-term structure risk factors?
The following is reproduced from the Prospectus of the T. Rowe Price Institutional Core Plus Fund dated October 1, 2010:“Principal Investment Strategies: The fund intends to invest at least 65% of
What are the limitations of using duration and convexity measures in active portfolio strategies?
Below are two portfolios with a market value of $500 million. The bonds in both portfolios are trading at par value. The dollar duration of the two portfolios is the same.Answer the below
Answer the below questions.(a) Explain why you agree or disagree with the following statement: “It is always better to have a portfolio with more convexity than one with less convexity.”(b)
A portfolio manager owns $5 million par value of bond ABC. The bond is trading at 70 and has a modified duration of 6. The portfolio manager is considering swapping out of bond ABC and into bond
Explain why in implementing a yield spread strategy it is necessary to keep the dollar duration constant.
The excerpt that follows is taken from an article titled “Smith Plans to Shorten,” which appeared in the January 27, 1992, issue of BondWeek, p. 6:“When the economy begins to rebound and
Explain how it can be possible for a portfolio manager to outperform a benchmark but still fail to meet the investment objective of a client.
The following excerpt is taken from an article titled “MERUS to Boost Corporates,” which appeared in the January 27, 1992, issue of BondWeek, p.6:MERUS Capital Management will increase the
This excerpt comes from an article titled “Eagle Eyes High-Coupon Callable Corporates” in the January 20, 1992, issue of BondWeek, p. 7:“If the bond market rallies further, Eagle Asset
The following excerpt comes from an article titled “Securities Counselors Eyes Cutting Duration” in the February 17, 1992, issue of BondWeek, p. 5: “Securities Counselors of Iowa will shorten
The following appears in big bold letters in a publication by State Street Global Investors’ publication, “Beyond Active and Passive: Advanced Beta Comes of Age” (2014): But in recent years, a
Describe the underlying principle of a smart beta strategy.
What is the risk associated with the use of leverage?
Suppose that the initial value of an unlevered portfolio of Treasury securities is $200 million and the duration is 7. Suppose further that the manager can borrow $800 million and invest it in the
Suppose a manager wants to borrow $50 million of a Treasury security that it plans to purchase and hold for 20 days. The manager can enter into a reverse repo agreement with a dealer firm that would
Two trustees of a pension fund are discussing repurchase agreements. Trustee A told Trustee B that she feels it is a safe short-term investment for the fund. Trustee B told Trustee A that repurchase
Suppose that a manager buys an adjustable-rate pass-through security backed by Freddie Mac or Fannie Mae, two government-sponsored enterprises. Suppose that the coupon rate is reset monthly based on
Answer the below questions.(a) What is meant by the duration problem associated with a market-cap-weighted bond market index?(b) Why is the duration of bond index a “historical accident”?(c) What
Why is there credit risk in a repo transaction?
Why is an investor concerned with how the investment characteristics of a market-cap-weighted bond index can change over time?
Answer the below questions.(a) Why does an issuer-capped bond index overcome the bum’s problem?(b) Does an issuer-capped bond index overcome the duration problem associated with a
In “Portfolio Strategies for Outperforming a Benchmark” (appearing in Handbook of European Fixed Income Securities published by John Wiley & Sons in 2003), the authors, William Lloyd and Bharath
The following two quotes are from the website for the FTIF Franklin High Yield Fund dated December 31, 2009(www.franklintempleton.com.es/pdf/funds/fdata/0825_ksp_es.pdf):a. “Portfolio risk is
Answer the below questions.a. What is the essential ingredient in all active portfolio strategies?b. Those portfolio managers who follow an indexing strategy are said to be “index huggers.” Why?
Explain whether you agree or disagree with the following statement: “All duration-matching strategies are indexing strategies.”
What is the major insight provided by the Markowitz framework in portfolio theory?
Answer the below questions.(a) Compute the tracking error from the following information:(b) Is the tracking error computed in part (a) a backward-looking or forward-looking tracking error?(c)
Assume the following:benchmark index = Salomon Smith Barney BIG Bond Indexexpected return for benchmark index = 7%forward-looking tracking error relative to Lehman Aggregate Bond Index = 200 basis
At a meeting between a portfolio manager and a prospective client, the portfolio manager stated that her firm’s bond investment strategy is a conservative one. The portfolio manager told the
What is meant by tracking error due to systematic risk factors?
You are reviewing a report by a portfolio manager that indicates that a fund’s predicted (forward-looking) tracking error is 94.87 basis points. Furthermore, it is reported that the predicted

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