class 5: fixed income

Question 1

would we choose a bond with a longer or shorter duration

Answer 1

shorter one

Question 2

duration formla

Answer 2

sum of (all the weights of of all PVs of cashflow from total PV · t)

t = year

Question 3

a bond with higher interest rate has a higher or lower duration

Answer 3

lower duration

Question 4

cash flow matching benefits

Answer 4

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

Question 5

cash flow matching wanks

Answer 5

difficult to achieve

need to rebalance

high transaction costs

no returns

(callable bonds)

(defaults)

Question 6

horizon matching***

Answer 6

hybrid approach

CF matching + duration matching

Question 7

when we want to immunize, do we match term of a bond with out liability or the bond’s duration?

Answer 7

duration

Question 8

duration matching

Answer 8

to immunize

you get a bond with equal duration of our liability

Question 9

contingent immunization

Answer 9

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

Question 10

pure indexing

Answer 10

replication of bond index

active return = 0

active risk = 0

Question 11

pure indexing disadvantages

Answer 11

tracking error

impossible to replicate

active return always < 0

high transaction costs

rebalancing

Question 12

enhanced indexing

Answer 12

replication with minor deviations

possible small alpha

–> alpha likely modest

higher management fees

Question 13

active management

Answer 13

beat our index

sweet alpha

most underperformed

high cost

Question 14

axioms for bonds

Answer 14

1. inverse relationship between bond price and interest rates
2. LT bonds more sensitive to YTM changes than ST bonds
3. sensitivity of bond prices to yield increases decreases as we approach maturity
4. a bond’s price sensitivity is inversely related to the bond’s coupon

–> bonds with with lower coupons are more sensitive

5. 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

6. an increase in a bond’s YTM in results in a small price decline than the gain associated with a decrease in yield

–> convexity

Question 15

managers want higher or lower bond convexity

Answer 15

higher convexity

Question 16

types of way to create our duration with money allocation

Answer 16

even ladder (worst case scenario)

–> we have no flexibility nor leverage

bullet

barbell

Question 17

stable yield curve

Answer 17

we don’t expect rates to change in the coming future

–> both short and long term

Question 18

how do we allocate our money to create an appropriate duration when we have a stable yield curve

Answer 18

1. buy and hold:

–> extend duration to add yield

–> low turnover

2. roll down, ride the curve:

–> buy at a higher yield

–> sell as the yield drops and price increases

3. 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

4. carry trade:

–> just buy and hold it

Question 19

how can a yield curve shift

Answer 19

1. parallel (least common highly unlikely)
2. flattening
3. steepening
4. twist
5. condor
6. butterfly

Question 20

bond with a higher coupon would have a higher or lower duration?

Answer 20

lower

Question 21

what should we do when expect yield curves to flatten?

why?

Answer 21

barbells outperform in a flattening curve

Question 22

how should we allocate our money to create our duration when we expect yield curves to flatten?

why?

Answer 22

barbells outperform in a flattening curve

Question 23

how should we allocate our money to create our duration when expect yield curves to steepen upwards?

Answer 23

bullets outperform in a steepening curve

Question 24

how should we allocate our money to create our duration when we expect yield curves to do a deepening twist upwards?

Answer 24

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

Question 25

how should we allocate our money to create our duration when we expect yield curves to do a flattening twist upwards?

Answer 25

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

Question 26

how should we allocate our money to create our duration when we expect yield curves to do a positive butterfly?

Answer 26

bullet

–> you put everything when rates decrease (medium term) and you have nothing on both ends when rates increase (short term and long term)

Question 27

how should we allocate our money to create our duration when we expect yield curves to do a negative butterfly?

Answer 27

barbell

–> we put money when rates decrease (short term and long term) and we pull out when rates increase (in the medium term)

Question 28

active management techniques of

Answer 28

1. substitution swap
2. intermarket swap
3. rate anticipation
4. pure yield pickup

Question 29

substitution swap

Answer 29

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

Question 30

intermarket swap

Answer 30

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

Question 31

rate anticipation

Answer 31

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

Question 32

pure yield pickup

Answer 32

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