Level II Review, Structured Securities

Study session 15 in the Level II CFA Program curriculum concludes the fixed income material with three readings (45-47) on structured securities. As it is with much of the topic areas in the Level 2 curriculum, the formulas can get pretty intense but you need to spend some time and master them. The topic area is worth about 10% of your exam score and another 15% in the Level 3 exam.
 Mortgage-Backed Bonds
The reading starts out pretty basic with a glossary of MBS terms and differences between types of structure. Be able to calculate the mortgage payment, an easy task on the PV function of your calculator.
The two types of prepayment risk are important and you should know the difference between them. Contraction risk is that a security’s life will decrease when rates come down and borrowers prepay their loan. This means the investor will need to reinvest proceeds at a lower rate. Extension risk, that the security’s life will increase, is when rates increase and prepayments decrease. The price of the security will decline and the investor will be stuck in the lower rate longer.
Be able to calculate the single monthly mortality (SMM) and the conditional prepayment rate (CPR) assuming a PSA. The two formulas may seem inconsequential but they are probably the most easily testable part of the reading which is largely conceptual.
SMM = prepayment in month i/(beginning mortgage balance for month i – scheduled principal pmt month i)
CPR = 1- (1-SMM)12
The rest of the reading is fairly conceptual. Understand the tranche structure of CMO and the different classes of stripped MBS.
Asset-Backed Bonds
Understand the basic process of securitization and the parties involved. Types of credit enhancements is fairly testable, as much of the list material is.
External enhancements like a third-party guarantee, letter of credit or corporate guarantee expose the investor to third-party risk. Internal enhancements like reserve funds, excess spreads, overcollateralization, and senior-subordinate structures do not have the third-party risk.
The structure is similar for most of these securities, the differences in prepayment risk is probably the most important area. Credit cards and mobile homes do not have prepayment risk. Student loan prepayments are not sensitive to rates.
Know the concepts and structure for CDOs. There is a some quantitative material around an arbitrage transaction that you should do a few practice problems to understand but I’m not sure it is as testable as the other formulas in the topic.
Valuing Mortgage and Asset-Backed Securities
Understand the three assumptions (prepayment rate, reinvested at yield, held to maturity) of cash flow yield and be able to calculate the bond equivalent yield, BEY = 2((1+im)6 – 1)
As is the case throughout the curriculum, pay attention to the limitations on each yield measure (usually based around the assumptions).
Know the basic idea behind the five steps to valuation using Monte Carlo simulation:

  • simulate interest rate      path and cash flow using rates, volatility, and spread assumptions;
  • calculate the PV of cash      flows along 1,000 paths;
  • calculate theoretical      value of MBS as the average PV along all paths;
  • calculate OAS as the      spread that makes PV equal to market price;
  • calculate the option cost      as the zero-volatility spread minus the OAS

Duration is probably the most testable material in the reading, especially since you will need it in other topics. The formula may look intimidating at first but it is pretty intuitive. The price sensitivity to changes in rates is the (value at the lower rate minus value at the higher rate) divided by( twice the initial price times the change in rates)
Understand the different types of duration methods (cash flow, effective duration, coupon curve, empirical duration) and their limitations. The major criticism of cash flow duration is that it is based on the assumption of a single prepayment rate over the life of the security.
Study session 16 in the Level II CFA Program curriculum starts the material on derivatives with two readings on forwards and futures.
‘til next time, happy studyin’
Joseph Hogue, CFA


If it’s your desire to be the best
Please take the CFA Program Test.

Read more

Editable Excel Study Plan – Send to Your Inbox

Send Microsoft Excel + PDF files of CFA Program Study Plan to Your Inbox

Manage your subscriptions

CFA exam study material

For general inquiries, please write to us at info@finquiz.com. For pre-sales inquiries, get in touch at sales@finquiz.com.

CFA Institute does not endorse, promote or warrant the accuracy or quality of FinQuiz. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. BA II Plus is registered trademark owned by Texas Instruments.

Copyright © 2008-2018 FinQuiz:CFA Exam Prep. All rights reserved.
Terms and Conditions | Privacy Policy | info@finquiz.com

2019 Question Bank Levels I, II and III 112 Days 20 Hours 51 Minutes 18 Seconds
Question Bank