Chapter 11 - managing bond portfolios

Question 1

Propositions of bond prices and YTM

Answer 1

1. prices and yields are inversely related
2. more price sensitive to decreases in YTM than increases
3. longer maturity = more sensitivity
4. The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases
5. Interest rate risk is inversely related to the bond’s coupon rate
6. price sensitivity to changes in yield is inversely related to the YTM

Question 2

Macaulay’s duration

Answer 2

• measure of the effective maturity
• the weighted average of the time until each payment, with weights proportional to the present value of the payment

Question 3

what is the relationship between interest rate changes, duration, and price?

Answer 3

When interest rates change, the percentage change in a bond’s price is proportional to its duration

Question 4

modified duration and formula

Answer 4

Macaulay’s duration divided by 1 + YTM

Measures interest rate sensitivity of a bond

D* = D / (1+y)

ΔP/P = -D x Δy

Question 5

what determines duration?

Answer 5

Rule 2: duration and interest rate sensitivity are higher when the coupon rate is lower

Rule 3: duration and interest rate sensitivity increase with time to maturity

Rule 4: duration and interest rate sensitivity of a coupon bond is higher when the bond’s YTM is lower

Question 6

passive bond management view

Answer 6

take bond prices as fairly set and seek to control the risk of their portfolios

Question 7

immunization

Answer 7

• shielding net worth from interest rate movements
• by matching interest rate exposure of assets and liabilities
• When portfolio duration equals the investor’s horizon date, the accumulated value of the investment fund at the horizon fate will be unaffected by interest rate fluctuations
• must proactively update and monitor their positions

Question 8

rebalancing

Answer 8

Realigning the proportions of assets in a portfolio as needed

Question 9

cash flow matching

Answer 9

Matching cash flows from a fixed-income portfolio with those of an obligation

Question 10

dedication strategy

Answer 10

Multiperiod cash flow matching

Question 11

convexity and formula

Answer 11

The curvature of the price-yield relationship of a bond

ΔP/P = (-D x Δy) + (½ x Convexity x (Δy)2)

Question 12

horizon analysis

Answer 12

• Analysis of bond returns over a multiyear horizon, based on forecasts of YTM and the reinvestment rate of coupons
• Form of Interest rate forecasting
• Coupon income earned over the period is added to the predicted capital gain/loss to obtain a forecast of the total return on the bond over the holding period

Question 13

active bond management sources of potential profit

Answer 13

• horizon analysis
• identification of relative mispricing within the fixed-income section

Question 14

substitution swap

Answer 14

Exchange of one bond for a bond with similar attributes but more attractively priced

Question 15

inter-market spread swap

Answer 15

Switching from one segment of the bond market to another

Question 16

rate anticipation swap

Answer 16

A switch made in response to forecasts of interest rate changes

Question 17

pure yield pickup swap

Answer 17

Moving to higher-yield bonds, usually with longer maturities

Question 18

tax swap

Answer 18

Swapping two similar bonds; motivated by a reduction in total tax obligations

Question 19

formula for Macaulay’s duration

Answer 19

Wt (weight per cash flow) = (CFt / (1+y)t) / bond price

D = ∑ t x wt

Question 20

excel function for Macaulay’s duration

Answer 20

Excel: =DURATION(settlement date, maturity date, coupon rate, YTM, coupons per year)

Question 21

formula for price change of a bond by interest rate change and duration

Answer 21

ΔP/P = -D x [Δ(1+y) / (1+y)]

Question 22

excel function for modified duration

Answer 22

Excel: =MDURATION(settlement date, maturity date, coupon rate, YTM, coupons per year)