9.1) Managing Bond Portfolios (Chapter 16)

Question 1

What is active risk management vs passive risk management? (2)

Answer 1

Active management = Maximise returns
Passive management = Minimise risk

Question 2

What does passsive management assume?

Answer 2

• Assumes that market prices are fairly set (Market Efficient: Pointless looking for opportunities because of prices are correct)

Question 3

What type of risk does does passive management seek to control?

Answer 3

Only seek to control the risk of their bond portfolio = Interest rate risk

Question 4

What are the characteristics of active risk management strategies? (4)

Answer 4

1) Based on the belief that the market misprices securities (Undervalued and overvalued assets)
2) Trade on market inefficiencies (The skills and knowledge and skill to identify and act on market inefficiencies)
3) To predict market movements (Knowledge and skills to predict Interest rate movements and take a position)
4) Key source of return is capital gain

Question 5

What are both concepts concerned with? (2)

Answer 5

• Passive – Fears interest rate risk
• Active – Take advantage on this opportunity of interest rate risk

Question 6

What does Warren Buffet say about managing bond portfolios? (2)

Answer 6

o Rule No. 1: Never lose money.
o Rule No. 2: Don’t forget rule No.1

Question 7

What sources of bond returns are affected by interest rate returns? (2)

Answer 7

1) Reinvestment risk
2) Price risk

Question 8

How does interest rate risk affect reinvestment of coupons? (2)

Answer 8

• Affects the income from the reinvestment of coupons.
• The possibility of your reinvestment income deviating from the expected income due to changes in interest rates.

Question 9

How does interest rate risks affect prices of bonds? (2)

Answer 9

• Affects capital gains/losses.
• The variability in bond prices caused by their inverse relationship with interest rates.

Question 10

What is the formula for bond price varaiblility/sensitivity?

Answer 10

Question 11

What are the properties of bond price sensitvity? (5)

NOTE: Principle 1 and 5 only

Answer 11

1. Inverse relationship between bond prices & yields Relate to convexity – Greater price appreciation than depreciation:
2. For small changes in yields, the price sensitivity of a given bond is roughly the same for an increase/decrease in yield (Small change = 0,5% or below)
3. For large changes in yields, the price sensitivity is not the same for an increase and a decrease in the required yield (Large change = 0,5% or above)
4. For large changes in yields for a given bond, The % price increase > % price decrease (Positive Convexity)
5. The price sensitivity [price change] is not the same for all bonds.

Question 12

What do you make of these two forms of Interest Rate risks ? (2)

Answer 12

• They offset each other
• If you structure your portfolio correctly it will create a zero effect of interest rate risk as they cancel each other out.

Question 13

Price risk will only affect your returns if you ______ . If you don’t sell you are ____________ (Unrealized losses)

Answer 13

sell
unaffected

Question 14

Price risk and reinvestment risk, which one matters more? (2)

Answer 14

• If you sell before maturity the price risk affects, you more
• If you hold to maturity, then reinvestment risk is what affects you more

Question 15

What factors affect bond price sensitivity? (3)

Answer 15

1) time to maturity
2) coupon rate
3) Yield to maturity (YTM)

Question 16

True or false, As yield to maturity decreases the sensitivity of bond prices increases at a decreasing rate

Answer 16

False, as time to maturity increases the sensitivity of bond prices increases at a decreasing rate

Question 17

Prices of _______ -term bonds are more ___________ to changes in interest rates than short-term bonds. The same change in years does not _______ the price change

Answer 17

long
sensitive
equal

Question 18

How does the coupon rate affec bond price sensistivity?

Answer 18

Prices of low-coupon bonds tend to be more sensitive to changes in interest rates than high-coupon bonds – interest rate risk is inversely proportional to coupons

Question 19

How does yield to maturity (YTM) affect bond price sensitvity?

Answer 19

Sensitivity of a bond’s price to a change in its yield is inversely related to the yield to maturity at which the bond currently is selling

Question 20

Summarise the factors that affect bond price senstivity and whether they offer low risk or high risk (3x3)

Answer 20

Question 21

How come, shorter time to maturity, high coupon rate and high yield to maturity = low price sensitivity ? (3)

Answer 21

• Common denominator is all these factors reduce the bonds effective maturity
• When you reduce the effective maturity, it means you are recovering the bond cash flows in a shorter period (Quicker we recover the less risk)
• Any factor that increases the effective maturity also increases sensitivity as it takes longer to recover the bond cash flows