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CFA Level 3 > Fixed Income > Flashcards

Fixed Income Flashcards

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1
Q

What are the three main benefits of Fixed Income in a portfolio

A
  1. Regular Cash Flows
  2. Diversification
  3. Inflation Hedging
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2
Q

What are the two main types of immunization/liability based fixed income approaches?

A
  1. Cash Flow matching (coupons and principal payments)

2. Duration Matching

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3
Q

Why would a cash flow based immunization strategy rebalance?

A

If there are cost savings to be had

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4
Q

What are the two conditions to achieve immunization using duration matching?

A
  1. PV of assets and liabilities are the same

2. Durations are equal

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5
Q

How do you adjust for options in bonds when immunizing?

A

Effective rather than ModDuration

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6
Q

What is the key limitation to duration matching?

A

It only accounts for parallel yield curve shifts

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7
Q

What is contingent immunization?

A

You manage the portfolio until it hits the PV of a specific threshold. This applies when PV of assets are higher than liabilities

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8
Q

What is horizon matching?

A

Short term needs are covered through CF matching, whereas long term are covered through duration matching

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9
Q

How can you decompose fixed income returns?

A 
Expected Return =
E Yield (coupon + Reinvestment) + E Rolldown + E Change of YC - E Credit Losses + E Currency Gains
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10
Q

What is rolldown return and how do you calculate it?

A

Rolldown = Price End - Price Beg/Price B

This is a function of pulling to par.

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11
Q

How do you calculate the expected change in bond prices based on yield expectations?

A

= -MD*Yield Change + (1/2 * Convexity *Yield Change ^2

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12
Q

What are the drawbacks of the simple fixed income return decomposition equation?

A
  1. Ignores local price effects

2. Assumes CF reinvested at YTM

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13
Q

How can you decompose the effect of leverage on the portfolio?

A

Return = Asset Return + (Value of Borrowing/Value of Equity)*(return-borrowing rate)

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14
Q

How do futures contracts add leverage?

A

You have exposure without transacting

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15
Q

How do you calculate futures leverage?

A

Leverage = Notional - Margin/Margin

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16
Q

What would a long position on an inverse floater express?

A

You believe that rates will stay low or decline over the life of the position

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17
Q

What is the rebate rate and why is it relevant?

A

A rebate rate is the amount that a security lender gives to the security borrowing when the yield on collateral exceeds the borrowing rate

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18
Q

What is the significance to Mac Duration?

A

Mac Duration is the exact time where the price effect and reinvestment effect offset eachother

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19
Q

How does the shape of the yield curve effect the difference between average duration and portfolio duration?

A

When the yield curve is flat they are equal, but when it is sloped upwards the portfolio duration will be higher.

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20
Q

What is dispersion statistic for duration and why does it matter?

A

Dispersion is the weighted variance of cash flows from the portfolio duration. For example, if the PV of cash flows at period 5 is 20% and the duration is 10, the variance is (5-10)^2*0.2. This is used to connect duration to convexity and manage structural risk (twists and steepening) when immunizing.

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21
Q

How is convexity related to MacDuration and Dispersion mathematically?

A

Convexity = MacDuration ^ 2 + MacDuration + Dispersion/(1+CF Yield)^2

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22
Q

What is the relationship between the current CF yield of a bond portfolio and the HPR in the context of immunization?

A

The goal is to have Current CF yield to equal the HPR, which implies that coupons are reinvested at the current Cf yield.

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23
Q

What are the interest rate risks to an immunization strategy?

A

If the CF yield is not the same on the immunized portfolio as the equivalent zero coupon bond (constantly). For example, a steepening twist could cause bond losses that do not follow that of a zero coupon bond.

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24
Q

How does a barbell vs bullet immunization approach affect structural risk?

A

A barbell portfolio has more structural risk as there is a greater dispersion around the portfolio duration. Bullet is the opposite.

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25
Q

Why is convexity a better stat to measure structural risk?

A

Minimizing dispersion and convexity are the same, but convexity can be approximated by averaging across portfolio. Individual bond dispersion is not, specifically with zero coupon bonds.

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26
Q

What are the three characteristics of a bond portfolio that immunizes a single liability?

A

1) Initial MV that is equal to or exceeds PV of liability
2) MacDuration matches liability
3) Minimizes convexity

27
Q

What is the risk of cash flow matching for multiple liabilities?

A

Pretty unlikely you’ll find bonds mature at exact points of CFs, so you will likely have cash sitting around between maturity and liability payments, increasing reinvestment risk

28
Q

How do you find the money duration?

A

ModDuration * MV

Mod duration = Maculay Duration/(1+ Cf yield)

29
Q

What are the two conditions of immunizing mutliple liabilities using duration matching?

A

BPV is the same for asset and liability portfolios, convexity in asset is higher than liability
However, if conditions are met, still minimize convexity

30
Q

Why would you use a derivatives overlay rather than duration or CF matching?

A

If for some reason you have a preference for a specific maturity range or have some liquidity needs,

31
Q

How do you know the number of futures contracts necessary to match your liability duration?

A

N = Liability BPv - Asset BPV/Futures BPV

32
Q

How do you know the futures BPV?

A

You dont, but you need to estimate using CTD BPV/Con Factor

33
Q

What is contingent immunization? Why would you use it?

A

This is when you pursue a total return strategy until you reach a certain lower bound on plan surplus

34
Q

When would you overhedge your futures (interest rate, T Bill futures)?

A

When you expect rates to drop

35
Q

What is an example of type 2, 3, 4 liabilities?

A

2 - Callable bond (amounts, not dates)
3 - Floaters (dates, not amounts)
4 - DBPP - neither

36
Q

How do you know the notional on an interest rate swap to cover off a duration gap?

A

FRN are very low, so one receiving fixed on the swap is adding duration. N = Liabilty BPv - Asset BPV . Swap BPV * 100

37
Q

How can you use a swaption to hedge/bet on interest rates?

A

A receiver swaption gives someone the option to enter an interest rate swap at a certain interest rate. If the prevailing rates are higher, the option is out of the money. If rates drop you make money, which offsets the increase in the PV of the liability you’re hedging

38
Q

What is a swaption collar?

A

This is when you buy a receiver swaption and write a payer swaption. You would buy the reciever swaption OTM which is below current rates. You would write the payer OTM at higher rates. The purpose is to have a zero cost position. If rates go up, the owner of the swaption you sold will exercise and you will only receive the strike, which is lower than market rates. If the rates go lower past the strike of the reciever swpation, you make money.

39
Q

What is a payer swpation?

A

This is when you have the option to enter and interest rate option as the payer - in other words, this is the option to lock in a lower rate of an interest rate swap, so you make money when rates increase.

40
Q

What is teh basic equation governing asset liability hedging?

A

Asset BPV * Delta Asset Yield + Hedge BPV * Delta Hedge Yields = Liability BPv * Delta Liability Yield

41
Q

What are the biggest risk of liability driven hedging strategies?

A
  1. Mismeasuring of duration - specifically with other asset classes
  2. Approximation of hedge BPV
  3. Yield curve twists
  4. Credit spreads on corporate bond yields
42
Q

What are the primary risk factors that can be used by a FI PM to help match an index?

A
  1. Duration, OA duration, Convexity
  2. Ket rate duration
  3. Sector and Quality
  4. Sector and Spread duration contributions
  5. Callable bond weighting
  6. Issuer exposure
43
Q

What is the PV of distribution of cash flows methodology for managing FI index funds?

A
  1. Divide CFs into semi annual buckets
  2. Calculate PV of each semi annual period.
  3. Multiply the time by the PV of each bucket (duration)
  4. Add all durations together
44
Q

What is the bums problem?

A

This is when you hold a value weighted FI index which will automatically increase the weighting in a company who issues more debt, which does not have a positive relationship to credit ratings

45
Q

What is the butterfly spread?

A

This measures the curvature of the yield curve.

Spread = -short yield + (2*mid-yield) - long yield

46
Q

How does convexity matter when yield change?

A

Convexity means prices go up more when rates decrease, go down less when rate increase - this is our friend. However, higher convexity typically means lower yields. Longer term bonds have higher convexity

47
Q

What is convexity for complex bonds?

A

About Duration^2

48
Q

What are the primary yield curve strategies when the yield curve is stable?

A
  1. Buy and hold - longer duration gets more yield
  2. Ride YC - As a bond ages, it will decline in yield (go up in value). This is because a normal yield curve is upward sloping. This is a bet that spots don’t evolve into forwards.
  3. Sell Convexity - higher convexity = lower yield, sell covered calls, sell puts on bonds you would actually want. (callable bonds and MBs have negative convexity, so could want to own)
  4. Carry Trades - simply cross currency/market or credit spreads, buy bonds and finance in REPO market, enter a received fix, pay floating IR swap
49
Q

Explain the different carry trades when you expect YCs to be stable:

A
  1. Simply borrowing in funding countries
  2. receive fixed interest rate swaps (long vs short rates)
  3. Long bond futures contract
  4. Currency swaps
  5. Borrow in high rate currency, buy security in high rate country, sell in repo market, buy forward contract
50
Q

How do you capitalize on the difference in yield curve shapes across currencies?

A
  1. Borrow ST rates in the steep curve, invest in the shallow - still have currency risk
  2. You must lend in the same currency you borrow in, and vice versa
    For example: CAD St rate is 1%, LT is 4%
    USD rate is 3%, LT is 4.5%
    Borrow at 1% in canada, lend at 3% in US =2%
    Lend at 4% in Canada, borrow at 4.5% in US = -0.5%
    Make 1.5% currency neutral
51
Q

How do you find the PVBP?

A

MV*ModDur/10K

52
Q

How would you buy convexity?

A

You must add instruments with lots of curvature. This could be through options or swaptions

53
Q

How do you find the duration of an option?

A

Duration = delta * Duration * Leverage
Leverage is measured by price of underlying/option price
Therefore, deeper OTM means higher leverage, lower delta

54
Q

When would you use bullet and barbell strategies?

A
  1. Use bullets in anticipation of steepening

2. Barbells when yield curve is flattening

55
Q

How does buying a bond financed through the repo market make money?

A

This is a trade that is typically predicated on a stable yield curve. You buy long bonds that have higher coupons than ST repo rates and make the spread.

56
Q

How does one execute an intra-market carry trade using swaps?

A

The best way would be an interest rate swap where you receive fixed and pay floating. The swap rate is based on an upward sloping yield curve. If the curve stays (does not evolve into the forward yield curve), you are paying ST rates that are smaller than the rate you recieve.

57
Q

How can you execute an inter market carry trade when needing to finance in the high interest rate currency?

A

First, you take the loan in the higher rate. Second, you invest in the asset in that currency. Then you buy the higher rate currency in the futures market. The higher rate future will trade at a discount.

58
Q

How do bullet and barbells perform differently when yield curves change?

A

Flattening YC is better for barbell, bullet is better for steepening

59
Q

What is a fixed income butterfly trade?

A

This is when you take long and short positions in bullet and barbell portfolios. For example, you could be long a barbell and short a bullet. A butterfly have long wings when it has high convexity (in the case of the example above).

60
Q

What is a fixed income condor?

A

This is when you are long the short and long end and short two mid term maturities. Each leg is done on a duration neutral basis. A barbell condor makes money when curvature increases.

61
Q

You expect spreads to decline in one market (say greece compared to EU), but expect EURO rates to rise, how could you use an asset swap?

A

There are several considerations..
1. If you expect EURO rates up, you don’t want duration
2. If you expect rates in Greece to decline, you want duration
3. If you expect spreads to compress, you want to trade current greek yields for current EURO yields.
You could counter this by making two bets, related but separate. If you want to benefit from spreads, buy EURO bonds. If you want to benefit from increasing yields in EURO, you can either short bonds or enter a swap where you pay fixed receive floating.
this is known as an asset swap, as you’ve transformed the bond into a floating rate

62
Q

Why would you enter an inter-market YC trade?

A

This is driven primarily by anticipated spread changes between markets.

63
Q

Explain why currency hedging (selling FX forward) does not eliminate all interest rate differential risk across countries

A

Say you buy a 10 year and sell base currency (USD) forward at 110 CAD/USD - this means that the USD costs 110 CAD. The forward is dated for three months. in three months, you must settle (buy USD at spot). Lets say since then, USD short rate differntial has increases. When base currency ST interest rate spread increases, futures rates go down (covered interest rate parity), say to 100, and spot is at 105. You would need to purchase USD for 105 CAD, and sell it for 110 CAD, making money. More commonly, you’d roll over the hedge, meaning offsetting the contract. in this case, you made money. If USD rates went down, futures price would go up and likely spot. This would cost money. in essence, hedges are exposed to interest rate risk on the short end.

CFA Level 3 (28 decks)

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