Chapter 11-13 Fixed-Income

Question 1

Accounting defeasance

Answer 1

Also called in-substance defeasance, accounting defeasance is a way of extinguishing a debt obligation by setting aside sufficient high-quality securities to repay the liability.

Question 2

Active management

Answer 2

A portfolio management approach that allows risk factor mismatches relative to a benchmark index causing potentially significant return differences between the active portfolio and the underlying benchmark.

Question 3

Active return

Answer 3

Portfolio return minus benchmark return.

Question 4

Active risk

Answer 4

The annualized standard deviation of active returns, also referred to as tracking error (also sometimes called tracking risk).

Question 5

Barbell

Answer 5

A fixed-income investment strategy combining short- and long-term bond positions.

Question 6

Bear flattening

Answer 6

A decrease in the yield spread between long- and short-term maturities across the yield curve, which is largely driven by a rise in short-term bond yields-to-maturity.

Question 7

Bear steepening

Answer 7

An increase in the yield spread between long- and short-term maturities across the yield curve, which is largely driven by a rise in long-term bond yields-to-maturity.

Question 8

Bull flattening

Answer 8

A decrease in the yield spread between long- and short-term maturities across the yield curve, which is largely driven by a decline in long-term bond yields-to-maturity.

Question 9

Bull steepening

Answer 9

An increase in the yield spread between long- and short-term maturities across the yield curve, which is largely driven by a decline in short-term bond yields-to-maturity.

Question 10

Bullet

Answer 10

A fixed-income investment strategy that focuses on the intermediate term (or “belly”) of the yield curve.

Question 11

Butterfly spread

Answer 11

A measure of yield curve shape or curvature equal to double the intermediate yield-to-maturity less the sum of short- and long-term yields-to-maturity.

Question 12

Butterfly strategy

Answer 12

A common yield curve shape strategy that combines a long or short bullet position with a barbell portfolio in the opposite direction to capitalize on expected yield curve shape changes.

Question 13

Carry trade across currencies

Answer 13

A strategy seeking to benefit from a positive interest rate differential across currencies by combining a short position (or borrowing) in a low-yielding currency and a long position(or lending) in a high-yielding currency.

Question 14

Cash flow matching

Answer 14

Immunization approach that attempts to ensure that all future liability payouts are matched precisely by cash flows from bonds or fixed-income derivatives.

Question 15

Cell approach

Answer 15

Stratified sampling A sampling method that guarantees that subpopulations of interest are represented in the sample. Also called representative sampling or cell approach.

Question 16

Contingent immunization

Answer 16

Hybrid approach that combines immunization with an active management approach when the asset portfolio’s value exceeds the present value of the liability portfolio.

Question 17

Covered interest rate parity

Answer 17

The relationship among the spot exchange rate, the forward exchange rate, and the interest rate in two currencies that ensures that the return on a hedged (i.e., covered) foreign risk-free investment is the same as the return on a domestic risk-free investment. Also called interest rate parity.

Question 18

Duration matching

Answer 18

Immunization approach based on the duration of assets and liabilities. Ideally, the liabilities being matched (the liability portfolio) and the portfolio of assets (the bond portfolio)should be affected similarly by a change in interest rates.

Question 19

Duration times spread

Answer 19

Weighting of spread duration by credit spread in order to incorporate the empirical observation that spread changes for lower-rated bonds tend to be consistent on a percentage, rather than absolute, basis.

Question 20

Duration Times Spread (DTS)

Answer 20

Weighting of spread duration by credit spread to incorporate the empirical observation that spread changes for lower-rated bonds tend to be consistent on a percentage rather than absolute basis.

Question 21

Enhanced indexing approach

Answer 21

Maintains a close link to the benchmark but attempts to generate a modest amount of outperformance relative to the benchmark.

Question 22

Enhanced indexing strategy

Answer 22

Method investors use to match an underlying market index in which the investor purchases fewer securities than the full set of index constituents but matches primary risk factors reflected in the index.

Question 23

Evaluated pricing

Answer 23

Matrix pricing An approach for estimating the prices of thinly traded securities based on the prices of securities with similar attributions, such as similar credit rating, maturity, or economic sector. Also called evaluated pricing.

Question 24

Full replication approach

Answer 24

When every issue in an index is represented in the portfolio, and each portfolio position has approximately the same weight in the fund as in the index.

Question 25

Immunization

Answer 25

An asset/liability management approach that structures investments in bonds to match (offset) liabilities’ weighted-average duration; a type of dedication strategy.

Question 26

Key rate duration

Answer 26

A method of measuring interest rate sensitivities of a fixed-income instrument or portfolio to shifts in key points along the yield curve.

Question 27

Liability-based mandates

Answer 27

Mandates managed to match or cover expected liability payments (future cash outflows) with future projected cash inflows.

Question 28

Matrix pricing

Answer 28

An approach for estimating the prices of thinly traded securities based on the prices of securities with similar attributions, such as similar credit rating, maturity, or economic sector. Also called evaluated pricing.

Question 29

Matrix pricing (or evaluated pricing)

Answer 29

Methodology for pricing infrequently traded bonds using bonds from similar issuers and actively traded government benchmarks to establish a bond’s fair value.

Question 30

Negative butterfly

Answer 30

An increase in the butterfly spread due to lower short- and long-term yields-to-maturity and a higher intermediate yield-to-maturity.

Question 31

Options on bond futures contracts

Answer 31

Instruments that involve the right, but not the obligation, to enter into a bond futures contract at a pre-determined strike (bond price) on a future date in exchange for an up-front premium.

Question 32

Passive investment

Answer 32

In the fixed-income context, it is investment that seeks to mimic the prevailing characteristics of the overall investments available in terms of credit quality, type of borrower, maturity, and duration rather than express a specific market view.

Question 33

Positive butterfly

Answer 33

A decrease in the butterfly spread due to higher short- and long-term yields-to-maturity and a lower intermediate yield-to-maturity.

Question 34

Present value of distribution of cash flows methodology

Answer 34

Method used to address a portfolio’s sensitivity to rate changes along the yield curve. This approach seeks to approximate and match the yield curve risk of an index over discrete time periods.

Question 35

Pure indexing

Answer 35

Attempts to replicate a bond index as closely as possible, targeting zero active return and zero active risk.

Question 36

Rebate rate

Answer 36

The portion of the collateral earnings rate that is repaid to the security borrower by the security lender.

Question 37

Relative value

Answer 37

A concept that describes the selection of the most attractive individual securities to populate the portfolio with, using ranking and comparing.

Question 38

Repo rate

Answer 38

The interest rate on a repurchase agreement.

Question 39

Repurchase agreements

Answer 39

In repurchase agreements, or repos, a security owner agrees to sell a security for a specific cash amount while simultaneously agreeing to repurchase the security at a specified future date (typically one day later) and price.

Question 40

Reverse repos

Answer 40

Repurchase agreements from the standpoint of the lender.

Question 41

Scenario analysis

Answer 41

What-if analysis that involves changing multiple assumptions at the same time in order to evaluate the change in an investment’s value.

Question 42

Smart beta

Answer 42

Involves the use of transparent, rules-based strategies as a basis for investment decisions.

Question 43

Spread duration

Answer 43

The change in bond price for a given change in yield spread. Also referred to as OAS duration when the option-adjusted spread (OAS) is the yield measure used.

Question 44

Stratified sampling

Answer 44

A sampling method that guarantees that subpopulations of interest are represented in the sample. Also called representative sampling or cell approach.

Question 45

Structural risk

Answer 45

Risk that arises from portfolio design, particularly the choice of the portfolio allocations.

Question 46

Surplus

Answer 46

The difference between the value of assets and the present value of liabilities. With respect to an insurance company, the net difference between the total assets and total liabilities(equivalent to policyholders’ surplus for a mutual insurance company and stockholders’ equity for a stock company).

Question 47

Swaption

Answer 47

This instrument grants a party the right, but not the obligation, to enter into an interest rate swap at a pre-determined strike (fixed swap rate) on a future date in exchange for an upfront premium.

Question 48

Total return payer

Answer 48

Party responsible for paying the reference obligation cash flows and return to the receiver but that is also compensated by the receiver for any depreciation in the index or default losses incurred by the portfolio.

Question 49

Total return receiver

Answer 49

Receives both the cash flows from the underlying index and any appreciation in the index over the period in exchange for paying the MRR plus a predetermined spread.

Question 50

Total return swap

Answer 50

A swap in which one party agrees to pay the total return on a security. Often used as a credit derivative, in which the underlying is a bond.

Question 51

Tracking error

Answer 51

The standard deviation of the differences between a portfolio’s returns and its benchmark’s returns; a synonym of active risk. Also called tracking risk. If returns are normally distributed, the portfolio’s return should be within +/? 1 standard deviation of the index’s return in 68% of time periods.

Question 52

Tracking risk

Answer 52

The standard deviation of the differences between a portfolio’s returns and its benchmark’s returns; a synonym of active risk. Also called tracking error.

Question 53

Conditions for Single Liability Immunization

Answer 53

MacDur(a) = IH(l)
Initial PV of Porfolio CFs(MVa) >= PV of Liability
Portfolio Convexity is minimized

Question 54

Conditions for Multiple Liability Immunization

Answer 54

MVa > PVl
DDa = DDl or BPVa = BPVl
Convexity A > Convexity L
-however after this is met lower convexity is better