Ch 6 trading & managing interest rate risk

Question 1

Normal Yield Curve:

• market expectations are that….
• time value of money

Answer 1

• market expectations are that interest rates will increase in the long term and a higher return is demanded as maturities lengthen
• time value of money: the longer the term you invest the greater the yield you will receive

Question 2

Inverse yield Curve

• Market expectations are:
• prospect of lower long term rates drives investors to…

Answer 2

• Market expectations are that interest rates are falling and will continue to fall in the future
• prospect of lower long term rates drives investors to buy longer dated securities (stronger demand pushes prices up / yields down)

Question 3

Flat Yield Curve

• market expectations:
• could also be

Answer 3

• market expectation are balanced at the current time and not forecast to rise or fall
• could also be that the curve is moving from a positive to a negative shape

Question 4

Humped curve

• market expectations
• could also be due to

Answer 4

• market expectations interest rates rise in short term (perhaps due to higher inflation) then interest rates pushed lower in the longer term
• could also be due to supply / demand for securities of certain maturity

Question 5

Parallel shift

Answer 5

entire curve moves an equal number of basis points over same time period

Question 6

Credit curve:

• CGS represent:
• credit curves differ due to

Answer 6

• CGS represent:

- credit curves differ due to perceived credit quality, liquidity and depth of market

Question 7

Types of Interest rate risk:

3

Answer 7

1. outright risk
2. basis risk
3. curve risk

Question 8

reinvestment risk

Answer 8

risk of not being able to invest coupon stream at the same rate that prevailed at time of issuance

Question 9

Risk management methods/measures (7)

Answer 9

1. gap analysis
2. PVBP
3. Duration
4. convexity
5. absolute measure
6. equivalent position methodology
7. value at risk

Question 10

Gap analysis

Answer 10

Divide risk positions into time buckets and analyse the grouped transactions

Question 11

PVBP

Answer 11

Present Value of a Basis Point
= dollar change in the price of a security for a 1 bp change in yield.
- pricing a bond at current mkt yield plus 1 bp will give you the PVBP (difference)
- can use average PVBP across whole portfolio to determine approx impact of 1 bp change

Question 12

Duration

• definition:
• also known as:
• zero coupon bond has a duration of:

Answer 12

• definition:
  measure of the appox sensitivity of the value of an instrument / portfolio to interest rate movements
• also known as Macauley Duration
• zero coupon bond has a duration of: equal to the maturity
  Duration converts an instrument with multi payments into an equiv pure zero coupon bond.
  time weighted net present value of all cashflows

Question 13

Modified Duration

• define
• formula

Answer 13

• define: measures sensitivity of a bond to changes in interest rates. Convert Duration to modified duration
• formula
  MD = (1/(1+i/k)) * duration
  k = coupon frequency
  Modified duration represents the percentage change in price for a 1% change in yield

Question 14

Convexity
- represents
- MD does not take into account:
3 factors to apply to convexity

Answer 14

• represents: curvature of the price/yield relationship
• MD does not take into account: curvature, assumes straight line
  3 factors to apply to convexity
  1. the longer the time to matyurtyt, the greater the convexity
  2. the lower the coupon rate, the greater the convexity
  3. the lower the yield, the greater the convexity

Question 15

Convexity always favours:

Answer 15

favours the bond holder; losses are cushioned and profits are escalated

Question 16

VaR

• what is it:
• based on:
• expressed as

Answer 16

• VaR calculates and predicts the value or capital at risk from positions that are held.
• based on: expected volatility and correlation given historical events
• expressed as limit of anticipated losses with a level of confidence - eg 95%

Question 17

VaR
Inputs (3)
Processes (2)
outputs (2)

Answer 17

inputs:
- risk positions
- parameters
- market data
Processes
- VaR calculator
- Volatilties/correlations
Outputs:
- VaR reports
- Limit and excess reports

Question 18

Different trading approaches for interest rate risk: (3)

Answer 18

1. strategic
   - longer term outlook in interest rate movement to maximise benefits
2. tactical
   - relies on timely and accurate identification of short term interest rate movements likely to arise from performance anomalies
3. technical
   - prediction of future price movements based on graphical and historic prices

Question 19

Arbitrageurs

- arbitrage techniques (3)

Answer 19

1. Cash & Carry
   - using debt instruments to raise funds for one maturity and investing them for a different term using a derivative to lock in the difference in maturities
2. Calendar spread
   (aka curve play or maturity play)
   - exploits anomaly in YC
3. Credit spread arbitrage
   - buy corporate spread on expectation that margin will perform

Question 20

Managing interest rate risk

1. Market maker

Answer 20

Market maker:
- products (limit number can deal in)
- amount of risk (eg PVBP, gap, VaR)
- credit quality
- amount of capital allocated
-

Question 21

Price takers

Answer 21

• tactical trading (timely and accurate identification of short term moves)
• strategic trading (longer term)
• technical trading (prediction of price movements through mathematical and graphical techniques)
• price takers may still incorporate hedging
• bank assigns limits not only to size, quality and capital usage of trader but also amount of capital risk in any transaction or across a series of transactions

Question 22

Arbitrageur

Answer 22

meant to be risk free, however some risks include

• change in demand/supply for particular security (may be rich or cheap due to demand / supply factors)
• change in funding expectation (duration of arbitrage - should the funding positions of the arbitrage not match, there is basis risk)

Question 23

Types of trading limits

Answer 23

• interbank and forward (for each dealer)
• intraday turnover limits (each dealer)
• n overall open positions in each product, currency, spot and forward
• maximum forward or borrowing or lending mismatches
• intraday open positions (interbank & forward, each dealer)
• overnight limits
• VaR limits at a trader, desk & room “global” level
• PVBP or delta limts for interest rate risk for trader’s portfolio & for a desk
• PVBP limits for each time bucket
• PVBP limits for each financial product type (limits basis risk)
• credit rating limits
• % of issue size limits (limits liq risk)
• desk and global limits (ie of entire dealing room

Question 24

Calculating Futures PVBP

Answer 24

1. Remember, SD = expiry of contract
2. Standard features (6% coupon)
3. No accrued, calculate change in price for 1bp move
4. PVBP = contract size 100,000 x calcbp / 100
5. Remember initial calc for change is per $100
6. to hedge bond exposure: PVBP bond / PVBP futures x face value