class 5: fixed income Flashcards
would we choose a bond with a longer or shorter duration
shorter one
duration formla
sum of (all the weights of of all PVs of cashflow from total PV · t)
t = year
a bond with higher interest rate has a higher or lower duration
lower duration
cash flow matching benefits
immunizations $1 cash : $ liability
perfect mirroring of CF : liabilities
no reinvestment needed
a liability based investment strategy
you put the money somewhere where you don’t touch it, so you eliminate the risk of losing it
cash flow matching wanks
difficult to achieve
need to rebalance
high transaction costs
no returns
(callable bonds)
(defaults)
horizon matching***
hybrid approach
CF matching + duration matching
when we want to immunize, do we match term of a bond with out liability or the bond’s duration?
duration
duration matching
to immunize
you get a bond with equal duration of our liability
contingent immunization
a hybrid approach
liabilities: immunization
surplus: active management
–> possibility of alpha return (only if surplus exists)
possibility of loss of we try to gamble we surplus we do not have
pure indexing
replication of bond index
active return = 0
active risk = 0
pure indexing disadvantages
tracking error
impossible to replicate
active return always < 0
high transaction costs
rebalancing
enhanced indexing
replication with minor deviations
possible small alpha
–> alpha likely modest
higher management fees
active management
beat our index
sweet alpha
most underperformed
high cost
axioms for bonds
- inverse relationship between bond price and interest rates
- LT bonds more sensitive to YTM changes than ST bonds
- sensitivity of bond prices to yield increases decreases as we approach maturity
- a bond’s price sensitivity is inversely related to the bond’s coupon
–> bonds with with lower coupons are more sensitive
- Sensitivity of a bond’s price to a change in its yield is inversely related to the YTM at which the bond is currently selling
–> bonds with lower YTM are more sensitivity
- an increase in a bond’s YTM in results in a small price decline than the gain associated with a decrease in yield
–> convexity
managers want higher or lower bond convexity
higher convexity
types of way to create our duration with money allocation
even ladder (worst case scenario)
–> we have no flexibility nor leverage
bullet
barbell
stable yield curve
we don’t expect rates to change in the coming future
–> both short and long term
how do we allocate our money to create an appropriate duration when we have a stable yield curve
- buy and hold:
–> extend duration to add yield
–> low turnover
- roll down, ride the curve:
–> buy at a higher yield
–> sell as the yield drops and price increases
- sell convexity:
–> sell calls and puts (adds income)
–> buy bonds with embedded options (adds yield)
–> we don’t need convexity, so we sell the ones with high convexity since they are worth more
- carry trade:
–> just buy and hold it
how can a yield curve shift
- parallel (least common highly unlikely)
- flattening
- steepening
- twist
- condor
- butterfly
bond with a higher coupon would have a higher or lower duration?
lower
what should we do when expect yield curves to flatten?
why?
barbells outperform in a flattening curve
how should we allocate our money to create our duration when we expect yield curves to flatten?
why?
barbells outperform in a flattening curve
how should we allocate our money to create our duration when expect yield curves to steepen upwards?
bullets outperform in a steepening curve
how should we allocate our money to create our duration when we expect yield curves to do a deepening twist upwards?
we should do a bullet because we would lose more money using barbell
–> yea we can make some in the beginning when rates decrease but because our bonds are more sensitive with long term maturities, the steepening increase will make us lose much more money
how should we allocate our money to create our duration when we expect yield curves to do a flattening twist upwards?
we do a barbell
–> we will lose money when rates go up in the beginning but in the longer term, they’ll go down and we will make much more money because bonds are more sensitive
how should we allocate our money to create our duration when we expect yield curves to do a positive butterfly?
bullet
–> you put everything when rates decrease (medium term) and you have nothing on both ends when rates increase (short term and long term)
how should we allocate our money to create our duration when we expect yield curves to do a negative butterfly?
barbell
–> we put money when rates decrease (short term and long term) and we pull out when rates increase (in the medium term)
active management techniques of
- substitution swap
- intermarket swap
- rate anticipation
- pure yield pickup
substitution swap
the exchange of one bond for another that has similar characteristics but offers a higher yield
used by investors when they think there may be a temporary discrepancy in bond prices that will soon be corrected by market forces
intermarket swap
an exchange, or sale, of one bond for another with different terms, such as a different coupon rate, credit rating, or maturity date, to capitalize on yield discrepancies between bond sectors
rate anticipation
selecting bonds that will increase the most in value from an expected drop in interest rates
A rate anticipation swap involves selling a group of bonds so that others can be purchased based on the expected change in interest rates
pure yield pickup
selling short-maturity bonds in exchange for longer-maturity bonds
The purpose of the strategy is to increase the total yield of the bond portfolio
