This tutorial is the second of two parts covering fixed income.  The subject of asset backed securities (of which mortgage backed securities are technically a large subset) may sound intimidating to some candidates, but this module is actually heavily conceptual.  Beyond memorizing a few formulas, there are a lot of definitions and ideas to absorb.  The few formulas presented should not be ignored, but ABS/MBS are commonly valued with sophisticated computer programs, which is beyond the scope of the exam.

With a general expectation of two fixed income item sets (twelve questions) on the exam, as much as one full item set’s worth of questions, six give or take, could come from the second fixed income session.

This module aligns with Study Session 15 material in the Level II CFA Program Curriculum ©.

NOTES:

The Fixed Income topics of the Level 2 exam draw heavily upon the foundation created in Level 1.  Candidates are strongly encouraged to review the following from Level 1:

• How to value annual pay bonds with a CFA approved calculator.

• How to value zero coupon bonds with a CFA approved calculator.

• The relationship between par, spot, and forward interest rates.

• The concept and formula to calculate a bond’s effective duration.

• Effective Duration = (Bond Price lower rate – Bond Price higher rate) / (2 * Bond Price current * change in interest rate)

• The concept and formula to calculate a bond’s convexity.

• Effective Convexity = (Bond Price lower rate + Bond Price higher rate - (2 * Bond Price current)) / (2 * Bond Price current * Δinterest rate2)

• Negative convexity of callable bonds on the price-yield graph.

• Price floor of a putable bond on the pried-yield graph.

Never, ever, ever, ever forget that the value of a bond moves inversely with interest rate changes!  If interest rates go up, then the value of the bond will drop.

Material:

I.          Mortgage Backed Securities (MBS)

II.        Asset Backed Securities (ABS) Market

III.       Valuation of MBS and ABS