BKM 16: Managing Bond Portfolios

Question 1

Relationship between interest rate risk and coupon rate

Answer 1

Inverse – prices of low-coupon bonds more sensitive to changes in interest rates

Question 2

Macaulay’s duration

Answer 2

Weighted average of the times to each payment

Question 3

Modified duration

Answer 3

D* = D / (1 + y), where y is YTM

Natural measure of bond’s exposure to interest changes

Question 4

Relationship between change in bond price and duration

Answer 4

Question 5

Relationship between change in bond prices, duration, and convexity

Answer 5

Question 6

Duration of a zero-coupon bond

Answer 6

Time to maturity

Question 7

Duration and coupon rate

Answer 7

Duration is lower when coupon rate is higher

Question 8

Duration and time to maturity

Answer 8

Duration increases with time to maturity

Question 9

Duration and YTM

Answer 9

Duration is higher when YTM is lower

Question 10

Duration of perpetuity

Answer 10

(1 + y) / y

Question 11

Convexity, graphed

Answer 11

Question 12

Effective duration

Answer 12

Question 13

Immunization

Answer 13

Strategies to shield finances from interest rate risk; set duration equal to investment horizon

Question 14

Two types of interest rate risk

Answer 14

Price risk

Reinvestment rate risk

Question 15

Rebalancing

Answer 15

Durations will change, need to be rebalanced

Transaction costs

Cannot be done continuously

Question 16

2 alternatives to immunization

Answer 16

Cash Flow Matching

Dedication Strategy

Question 17

Cash flow matching

Answer 17

Buying a zero that makes a payment exactly matching future cash obligation

Question 18

Dedication strategy

Answer 18

Cash flow matching over multiple periods

Question 19

Advantages to cash flow matching / dedication strategy

Answer 19

1. Automatically immunizes
2. No need to rebalance

Question 20

Disadvantage to cash flow matching / dedication

Answer 20

Hard to implement (constrained on bond selection)

Question 21

Problems with immunization

Answer 21

1. Assumes yield curve is flat
2. Inappropriate in inflationary environment
3. Only effective for parallel shifts in yield curve

Question 22

Substitution swap

Answer 22

Exchange of one bond for a nearly identical one (exploit perceived mispricing)

Question 23

Intermarket spread swap

Answer 23

When investor believes yield spread for two sectors of bond market is temporarily out of line

Question 24

Rate anticipation swap

Answer 24

Swapping to bonds of different durations based on interest rate forecasting

Question 25

Pure yield pickup swap

Answer 25

Means of increasing return by holding higher-yield bonds. When yield curve is upward-sloping, move to longer-term bonds

Question 26

Tax swap

Answer 26

Swap to exploit a tax advantage