Fixed Income Flashcards
Which has higher convexity, bullet or barbell?
Barbell
What is bull steepener?
Short term interest rates will fall by more than long term rates
Bear steepener
Long term rates will rise by more than short term rates
Bear flattener
Short rates will rise more than long term rates
Bull flattener
Long term rates will fall by more than short term rates
Callable bond is combination of
Option free bond and a short call option
Putable bond combination of
Option free bond and long put option
Define rolling yield
Sum of coupon income and roll down return
Which portfolio has most modified duration?
Barbell
Which has least modified duration?
Bullet
G spread
Bonds ytm (-) interpolated ytm of 2 adjacent maturity on the run government bonds
Yield spread
Bonds ytm minus the ytm of closest on the run government bond
I spread
Bonds ytm minus maturity of interpolated swap fixed rate
Asw spread
Bonds fixed coupon minus the maturity interpolated sfr
Anchoring bias
The anchoring bias is the tendency of the mind to give disproportionate weight to the first information it receives on a topic: initial impressions, estimates, or data, anchor subsequent thoughts and judgments.
Asset liability management strategy
Asset–liability management strategies consider both assets and liabilities in the portfolio decision-making process.
What’s yield curve inversion
Yield curve inversion is an extreme version of flattening in which the spread between long-term and short-term yields-to-maturity falls below zero
What’s immunization
Immunization is the process of structuring and managing a fixed-income portfolio to minimize the variance in the realized rate of return and to lock in the cash flow yield (internal rate of return) on the portfolio
Rules of immunizing a single liability
- Initial portfolio market value (PVA) equals (or exceeds) PVL. (There are exceptions to this for more complex situations where the initial portfolio IRR differs from the initial discount rate of the liability.)
- Portfolio Macaulay duration matches the due date of the liability (D = DL).
- Minimize portfolio convexity (to minimize dispersion of asset cash flows around the liability and reduce risk to curve reshaping).
- Regularly rebalance the portfolio to maintain the duration match as time and yields change. (But also consider the tradeoff between higher transaction costs from morefrequent rebalancing versus the risk of allowing durations to drift apart.)
Rules of immunizing multiple liabilities
- Initial portfolio market value (PVA) equals (or exceeds) PVL. (There are exceptions to this for some situations where the initial portfolio IRR differs from the initial discount rate of the liability.)
- Portfolio and liability basis point values match (BPV = BPVL)
- Asset dispersion of cash flows and convexity exceed those of the liabilities. (But not by too much, The dispersion, as measured by convexity, of the immunizing portfolio should be as low as possible subject to being greater than or equal to the dispersion of the outflow portfolio. This will minimize the effect of non-parallel shifts in the yield curve.)
- Regularly rebalance the portfolio to maintain the BPV match of A and L as time and yields change.
Covered bonds
Senior debt obligations of a commercial Bank backed by a pool of mortgages or loans made by the bank.
The key feature of a covered bond is that it provides dual recourse: investors have a claim on both the issuer and the underlying pool of assets if the issuer defaults.
If CDS spread is above standardized fixed coupon
Protection buyer needs to make upfront premium payment to the protection seller at initiation of contract
Structural models
Structural credit models
use market-based variables to estimate the market value of an issuer’s assets and the volatility of asset value. The likelihood of default is defined as the probability of the asset value falling below that of liabilities.
Reduced form models
Look for relationship between macroeconomic conditions and individual characteristics of a borrower such as financial ratios to infer default intensity for a bond issuer
Smart beta
Identifying relatively simple definable rules that can be followed to add value
Contingent immunization
It is a hybrid active/passive strategy that requires a significant surplus
Asset driven investing
Takes the assets as a given and manages or adjusts the liabilities in relation to those assets
Type 1, 2, 3 and 4 liabilities
(these are the type of LDI strategies)
- known future amounts and payout dates
- known future amounts but uncertain payout dates
- uncertain future amounts but known payout dates
- unknown everything
Repurchase agreement (repos)
An explicit way to borrow funds that could be used for leveraging. A securities owner sells a security for cash and simultaneously agrees to buy it back at a specified future date
credit spread volatility and interest rate volatility
more in investmnent grade bonds
CDS long short strategy
Buying protection on issuers where spreads are expected to widen relative to other issuers and shorting vice versa
positive key rate duration significance
manager expects interest rates to rise
Random interesting fact
If the yield curve is upward-sloping, buying bonds with a maturity beyond the investment horizon offers a total return (higher coupon plus price appreciation)
greater than the purchase of a bond with maturity matching the investment horizon if the curve remains static.
Bottom up credit strategies for credit strategies
Bottom-up credit strategies include the use of financial ratio analysis,
reduced form credit models (such as the Z-score model), and structural credit models, including Bloomberg’s DRSK mode
Fixed income is a good diversifier
has low correlation with equity
OAS spread
OAS is like the extra reward (in terms of higher interest or yield) you get from a bond compared to a risk-free bond (like a government bond) after accounting for the uncertainty caused by options built into the bond.
Duration neutral flattening strategy
A duration-neutral flattening trade involves taking opposite positions in short-term and long-term bonds such that the net duration exposure is zero, but the portfolio is positioned to benefit from changes in the slope of the yield curve
bottom up approach
The bottom-up approach involves selecting the individual bonds or issuers that the investor views as having the best relative value from among a set of bonds or issuers with similar characteristics (usually the same industry and often the same country of domicile).
Top down approach
The top-down approach involves the investor formulating a view on major macroeconomic trends, such as economic growth and corporate default rates, and then selecting the bonds that the investor expects to perform best in a given environment.
youve got this buddy
I have complete trust on you
In LDI, certain risks like longevity and inflation risks are not included
credit cycle charachteristics - Early expansion (recovery)
Economic Activity - Stable
Corporate Profitability - Rising
Corporate Leverage - Falling
Corporate Defaults - Peak
Credit Spread Level - Stable
Credit Spread Slope -Stable for high grade, inverted for low ratings
CCC - Late expansion
Economic Activity - Accelerating
Corporate Profitability - Peak
Corporate Leverage - Falling
Corporate Defaults - Falling
Credit Spread Level - Stable
Credit Spread Slope -Steeper for both higher
and lower ratings
CCC - Peak
Economic Activity - Decelerating
Corporate Profitability - Stable
Corporate Leverage - Rising
Corporate Defaults - Stable
Credit Spread Level - Rising
Credit Spread Slope - Steeper for both higher
and lower ratings
CCC - Contraction
Economic Activity - Declining
Corporate Profitability - Falling
Corporate Leverage - Peak
Corporate Defaults - Rising
Credit Spread Level - Peak
Credit Spread Slope Flatter for high grade, inverted
for low ratings
Reduced form models
Reduced form models solve for default intensity,
or the POD over a specific time period, using observable company-specific variables such as financial ratios and recovery assumptions as well as macroeconomic variables, including economic growth and market volatility measures.
what is a payer option on CDS index?
Option buyer pays premium for right to buy protection (“pay” coupons) on CDS index contract at a future date
what is a receiver option on CDS index?
Option buyer pays premium for right to sell protection (“receive” coupons) on CDS index contract at a future date
Role of fixed income securities in a portfolio
- Diversification benefits
- Benefits of regular cash flows
- Inflation hedging potential
Portfolio dispersion
Portfolio dispersion tells you how spread out those payment times are compared to the average waiting time (called duration).
Embedded call option reaction to volatility
Will increase as volatility rises, reducing the value of the bond versus a similar option-free bond, thus causing nominal spreads to increase.
MBS bond and convexity
An MBS is a bond with an embedded short call option. A short call option has negative convexity. Adding more MBS to a portfolio will decrease the
convexity of the portfolio and thus result in a smaller (not greater) benefit from a large change in interest rates.
what is a receiver swaption?
The plan buys an option to enter into a receive-fixed swap. If floating rate ends up below fixed rate
What are the different risks in liability driven investing while structuring liability
Here are brief explanations for each risk in liability-driven investing (LDI):
- Model Risk – This arises when the financial models used to estimate liabilities and investment returns are flawed or make incorrect assumptions, leading to inaccurate risk management and investment decisions. In LDI, reliance on imperfect models can result in underfunding or excessive risk exposure.
- Spread Risk – Spread risk refers to the possibility that the yield spread between corporate bonds and risk-free government bonds changes, affecting the valuation of assets. If credit spreads widen, the value of corporate bonds in an LDI portfolio may decline, impacting funding levels.
- Counterparty Credit Risk – This is the risk that a counterparty in a financial contract, such as a swap agreement, defaults on its obligations. In LDI, institutions often use derivatives to hedge liabilities, so counterparty failure could lead to unexpected financial losses.
- Asset Liquidity Risk – This is the risk that assets cannot be sold quickly at a fair price without causing a significant market impact. In LDI, illiquid assets can create challenges when adjusting portfolios to meet changing liabilities or funding needs.
Cash flow matching strategy
Cash flow matching involves aligning the cash flows from an investment portfolio to meet specific liabilities. This strategy ensures that the timing and amount of cash flows from investments perfectly offset the liability obligations.
Duration matching strategy
Duration matching aligns the duration of an investment portfolio with the duration of the liabilities. This minimizes the impact of interest rate changes on the portfolio’s ability to meet liabilities.
advantages and disadvantages of cash flow matching
Advantages
- Perfect Liability Coverage: Eliminates reinvestment risk since cash flows directly match liabilities.
- Simplicity: Once set, minimal adjustments are needed unless liabilities change.
Disadvantages
- high cost
- constrained universe
advantages and disadvantages of duration matching strategy
- hedging against interest rate changes
- flexible
Disadvantages - Imperfect liability coverage
- Complexity
why is there convexity?
A bond has greater convexity when its cash flows (coupons) are more widely dispersed around the duration point. A zero-coupon bond will have only one cash flow (i.e., at the time of maturity); therefore its dispersion around the duration point is the smallest.
Difference between asw and I spread?
I-spread: Compares the bond’s yield to the swap rate directly, useful for valuation and assessing credit risk relative to swaps.
ASW spread: Involves cash flows and reflects the bond’s total return relative to the swap, used primarily in trading and hedging.
Give me an example of ADL
With ADL, the asset side of the balance sheet results from a company’s under
lying businesses, and the debt manager seeks a liability structure to reduce interest rate risk. One example might be a leasing company with short-term contracts that
chooses to finance itself with short-term debt. The company is aiming to match the maturities of its assets and liabilities to minimize risk.
Liability based mandates
- Cash flow matching
- Duration matching
- Contingent Immunization
- Derivatives overlay
Total return mandates
- Pure indexing
- Enhanced indexing
- Active management
Key considerations for fixed-income analytical tools
- Accuracy of model inputs and assumptions
- alignment between model outputs and fixed-income manager objectives.
