Fixed Income

Question 1

Roles of Fixed income in portfolio

Answer 1

Diversification benefits
Regular cash flow
Inflation hedging potential

Question 2

Liability based

Answer 2

managed to match or cover expected liability payments with future projected cash inflows

Question 3

Cash flow matching

Answer 3

attempts to ensure all future liabilities are match by CFs from bonds (no need for reinvestment or bond sales)

Question 4

Duration matching

Answer 4

match the duration of the assets and liabilities
assets and liabilities should be affected similarly by a change in rates

Question 5

derivatives overlay

Answer 5

close duration gaps between assets and liabilities or alter risk exposures of the assets

Question 6

contingent immunization

Answer 6

when A>L, combines immunization with active management

Question 7

duration matching vs cash flow matching

Answer 7

complexity : High vs Low
rebalancing : frequent rebalancing required vs not required but desirable
YC assumption: parallel YC shifs vs None
mechanism: risk of shortfall minimized by matching duration and MV of liability stream vs bond portfolio match liabilities

Question 8

Total return mandates

Answer 8

Pure indexing : no deviation from risk factors, zero tracking risk
Enhanced indexing : match primary risk factors
Active management : deviation from primary risk factors

Question 9

Bond market liquidity

Answer 9

• very heterogenous
• typically OTC
• liquidity highest after issuance
• less active secondary market

Question 10

TRS as alternative to direct investment in bonds

Answer 10

• smaller intial outlay vs ETF and MFs
• investor doesn’t legally own the securities : rollover risk, require due dill
• allow investors to have access in subset of FI market
• need to collat mark to market position frequently

Question 11

leverage

Answer 11

rl(VE+Vb)-Vbrb/Ve

Question 12

methods of leverage

Answer 12

future contracts : gain exposure to underlying without actually transact it
swap agreement: collat may need to be posted
repurchase agreement:
security lending: collaterized by cash or high credit quality bonds

Question 13

risk of leverage

Answer 13

alters risk-returns properties of a portfolio
magnifies losses
higher risk
forced liquidation

Question 14

LDI

Answer 14

assets are managed to meet future liabilities

Question 15

ADL

Answer 15

assets are given and liabilities are driven to manage IR risk

Question 16

Laddered portfolio

Answer 16

provides both liquidity and diversification over time
spread bonds more/less evenly along the YC
better protection from structural risk
balance cash flow reinvestment and market price risk
bonds mature each year and are reinvested at the long end of the ladder
liquidity: always a bond close to redemption -> low duration, stable price

Question 17

Derivatives overlay

Answer 17

manage a duration gap without using assets

Question 18

contingent immunization

Answer 18

hybride passive-active strategy
MVa - MVl > 0
active investment strategy as operating under a total return mandate but if performance is poor and surplus evaporates return to passive strategy

Question 19

contingent immunization and rates change

Answer 19

if we expect lower rates (higher bond price), overhedge MVa so MVa rise in value and bring sensibilities

if we expect higher rates (lower bond price), underhedge MVa so MVa decline in value and remove sensibilities

Question 20

Risks in LDI

Answer 20

• Model risk : whenever assumptions are made on future events and used to assess key parameters
• Measurement error: approxmate portfolio duration with weighted average durations of individual bonds instead of cash flow yield
• spread risk: in derivatives, underluing of hedge may be treasuries but underlying of liabilities may be corpo bonds
• counterparty risk: when not collaterized

Question 21

Risk in swaption

Answer 21

spread risk
collaterization exhausted risk
credit risk

Question 22

quality of an index

Answer 22

unambiguous : components and weights are clearly defined
investable : all should be investable
measurable : index returns are readily calculable on a reasonably frequent basis

Question 23

ETFs as alternative to direct investment in FI

Answer 23

greater liqudity
can trade at discount that can persist and throught out the day

Question 24

Expectation of a static YC

Answer 24

Buy and hold : buy a bond with a duration greater than the benchmark
Rolling the YC : higher coupon income + capital appreciation by selling the bond at a higher price
Repurchase: buy a bond financed in the repo market

Question 25

YC inversion

Answer 25

Extreme version of flattening in which the spread between long term and short term YTM falls below zero

Question 26

Key rate duration

Answer 26

measure portfolio sensitivity over multiple maturities

Question 27

What cause a difference of YC between two countries ?

Answer 27

difference of inflation
difference of economic growth
difference of monetary/fiscal policy

Question 28

yield spread disadvantage

Answer 28

curve slope and maturity mismatch
will not be a good measure of carry return
only useful in relative value with bonds same maturity
benchmark can change over time

Question 29

I spread advantage

Answer 29

better used as a way to express the price of a bond relative to a curve
can more accurately measure carry return

Question 30

CDS basis

Answer 30

difference between the Z spread on an issue and the CDS spread of the same maturity for the same issuer
CDS spread - Z spread
negative basis trade = buy a bond, buy a CDS

Question 31

Structural credit model (bottom up)

Answer 31

use market variable to estimate asset value
define the likelihood of default as the prob of the assets falling below liab, with zero net assets

Question 32

Covered bonds perform relatively well in a downturn versus other fixed-income bonds with real estate exposure because the investor also has recourse to the issuer.

Question 33

CDOs are securities whose underlying cash flows are the interest and principal of the underlying debt instruments that are pledged as collateral. Whenever the value of a CDO is different from the value of its underlying collateral (in this example, the CDO value is lower as implied by the BB rating of its underlying debt instruments), an arbitrage opportunity exists.

Question 34

Liquidity risk

Answer 34

Liquidity risk is associated with exhausting available collateral funds to meet margin calls on derivative positions or to pay benefits.

Question 35

Model risk

Answer 35

Model risk refers to making incorrect assumptions regarding future liabilities or approximations being inaccurate.

Question 36

Spread risk

Answer 36

when hedging the liabilities, the yield of high-quality bonds is used in the discounting process, whereas most investment solutions use a more diversified and lower-quality portfolio of corporate bonds

Question 37

Portfolio with the lowest duration/convexity will suffer the less from rise in IR