Bond Risk Management Flashcards
There are 7 major risks to a bond holder, what are they?
1) Credit / Default Risk - Risk of issuer defaulting
2) Interest Risk (e.g. rates rise price falls, or rates fall and reinvestment opportunity changes)
3) Inflation Risk - Inflation can lead to rate rises
4) FX Risk - FX rates change when converting
5) Fiscal Risk - E.g. witholding tax increase
6) Issue Specific Risk - call options
7) Liquidity Risk - Can’t sell bond in secondary market (risk for smaller issues)
How can interest rate risk be mitigated?
Match duration with liability
Buy FRNs and step-up bonds.
How can inflation risk be mitigated?
Buy TIPS / Linkers
How can default risk be mitigated?
Investing in higher rated bonds
What is sensitivity to maturity?
Longer maturity increases the risk of holding a bond - longer dated bonds will see greater changes in price
What is sensitivity to coupon?
The lower the coupon on a bond the higher the risk / greater change in price.
What is Macaulay duration?
The effective maturity of a bond
It is the weighted average of the PV of payments
The longer the duration the longer the average maturity and therefore the greater sensitivity to interest rates
The longer the duration the longer the average maturity and therefore the greater sensitivity to interest rates
The longer the duration the longer the average maturity and therefore the greater sensitivity to interest rates
What increases duration?
Low Yields
Low Coupons
Long Maturities
Duration is one of the most useful ways of assessing the risk of holding a bond
What is modified duration?
Measures the change in price of a bond given a 1% change in yield
Expressed as a negative
What is convexity?
An estimate of the change in duration
- Duration assumes a straight line relationship (linear)
- Convexity measures the curvature of the line / relationship between price and yield
As convexity increases, the systemic risk of the portfolio increases.
Convexity vs Modified Duration
Modified overstates a drop in price
Modified understates a rise in price
For small movements in yield, modified is acceptablely accurate
What is basis point value?
Change in price if yield changes by one basis point
A more granular sensitivity measure
