Fixed Income

Question 1

How do you calculate the interpolated between two treasury yields?

Answer 1

(W1 × maturity1) + (W2 x maturity2) = maturity required

W2 = 1 - W1

Solve for W1

Question 2

What are the credit characteristics of an early expansion?

Answer 2

Stable economic activity
Rising corporate profitability
Falling corporate leverage
Corporate defaults peaked
Credit spread level stable
Credit spread slope stable for IG but inverted for HY

Question 3

What are the credit characteristics of a late expansion?

Answer 3

Accelerating economic activity
Peak corporate profitability
Stable corporate leverage
Falling Corporate defaults
Falling Credit spread level
Steeper for both IG and HY Credit spread slope

Question 4

What are the credit characteristics of a peak?

Answer 4

Decelerating economic activity
Stable corporate profitability
Rising corporate leverage
Stable Corporate defaults
Rising Credit spread level
Steeper credit spread slope for IG and HY

Question 5

What are the credit characteristics of a contraction/recession?

Answer 5

Declining economic activity
Falling corporate profitability
Peak corporate leverage
Rising Corporate defaults
Peak Credit spread level
Flatter slope for IG and inverted HY Credit spread slope

Question 6

What is the difference between liability-driven investing and asset-driven investing?

Answer 6

In ADL, the assets are given and the liabilities are structured to manage interest rate risk; whereas with LDI, liabilities are given and then assets are managed.

Question 7

What is a type I liability classification for LDI?

Answer 7

The amount and timing of cash outlay is known

Question 8

What is a type II liability classification for LDI?

Answer 8

The amount of cash outlay is known but the timing is not

Question 9

What is a type III liability classification for LDI?

Answer 9

The timing of the cash outlay is known but the amount is not known

Question 10

What is a type IV liability classification for LDI?

Answer 10

The amount and timing of cash outlay is not known

Question 11

What is portfolio immunisation?

Answer 11

Immunization is the process of structuring and managing a fixed-income portfolio to minimize the variance in the realized rate of return over a known investment horizon.

It is used to protect an investor from interest rate risk.

Question 12

What are the three types of portfolio immunisation?

Answer 12

Cash flow matching - attempts to ensure that all future liability payouts are matched precisely by cash flows
Duration matching - matching the duration of the assets and liabilities so that they are affected similarly by interest rate changes.
Contingent immunization - hybrid approach that combines immunization with an active management approach when assets exceed the present value of liabilities

Question 13

What are the three total return approaches to index matching?

Answer 13

Pure indexing - holding the majority of the benchmark with similar weights
Enhanced index - small deviations from the underlying benchmark, but most risk factors are matched, aiming for modest outperformance.
Active management - attempts to achieve high outperformance of the benchmark.

Question 14

What is structural risk and how do you reduce this risk?

Answer 14

Structural risk to immunization arises from some non-parallel shifts and twists to the yield curve.
This risk is reduced by minimizing the dispersion of cash flows in the portfolio, which can be accomplished by minimizing the convexity statistic for the portfolio. Concentrating the cash flows around the horizon date makes the immunizing portfolio closely track the zero-coupon bond that provides for perfect immunization.

Question 15

How do you immunise a single liability?

Answer 15

In the case of a single liability, immunization is achieved by matching the Macaulay duration of the bond portfolio to the horizon date. As time passes and bond yields change, the duration of the bonds changes and the portfolio needs to be rebalanced.

Question 16

What are the requirements for a fixed income benchmark?

Answer 16

Must have clear, transparent rules for security inclusion and weighting, investable, daily valuation and availability of past returns, and turnover.

Question 17

What is a bullet fixed income portfolio?

Answer 17

All cash flows happen at same time in a particular area of the yield curve

Question 18

What is a barbell fixed income portfolio?

Answer 18

One large cash flows at the start and one at the end

Question 19

What is a laddered fixed income portfolio?

Answer 19

Spread of cash flows

Question 20

What are the advantages of a laddered fixed income portfolio?

Answer 20

The laddered approach provides both diversification over time and liquidity. Diversification over time offers the investor a balanced position between two sources of interest rate risk: cash flow reinvestment and market price volatility. Laddered portfolios also have lower structural risks compared with bullet or barbell portfolios.

Question 21

What is a derivatives overlay approach to immunisation?

Answer 21

Interest rate derivatives can be a cost-effective method to rebalance the immunizing portfolio to keep it on its target duration as the yield curve shifts and twists and as time passes.

Question 22

How do you calculate the BPV of assets or liabilities?

Answer 22

Asset or liability value x modified duration x 0.0001

Question 23

How do you calculate a duration gap?

Answer 23

Liability Portfolio BPV - Asset Portfolio BPV

Question 24

If the manager’s view is that yields will be falling, will the manager over-hedge or under-hedge?

Answer 24

The manager will want to over hedge when yields are expected to fall. The manager will purchase more long futures contracts than needed. Long, or purchased, positions in interest rate futures contracts gain when futures prices rise and rates go down.

Question 25

Is a value-weighted or equal-weighted index more susceptible to credit quality deterioration?

Answer 25

Leverage and creditworthiness are negatively correlated, so a value-weighted index will be more susceptible to credit quality deterioration than an equally weighted index will be.

Question 26

What is a negative butterfly spread?

Answer 26

The investor is long short and long-term bonds, and short mid-term bonds. They believe that short- and long-term yields will fall, and medium-term yields will rise.

Question 27

What is a positive butterfly spread?

Answer 27

The investor is short short- and long-term bonds, and long mid-term bonds. They believe that short- and long-term yields will rise, and medium-term yields will fall.

Question 28

How do you calculate a butterfly spread?

Answer 28

Butterfly spread = −(Short-term yield) + (2 × Medium-term yield) − Long-term yield

Question 29

How do you calculate the excess spread return of a bond?

Answer 29

Excess spread ≈ Current spread − (Spread duration × change in spread)

Question 30

How do you calculate the excess spread return of a bond incorporating both default probability and loss severity?

Answer 30

Excess spread ≈ Current spread − (Spread duration × change in spread) − (POD × LGD)

Question 31

What is a bear steepener?

Answer 31

Long-term rates rise more than short-term rates

Question 32

What is a bear flattener?

Answer 32

Short-term rates rise more than long-term rates

Question 33

What is a bull steepener?

Answer 33

Short-term rates fall more than long-term rates

Question 34

What is a bull flattener?

Answer 34

Long-term rates fall more than short-term rates

Question 35

How do you calculate the rolling yield of a portfolio?

Answer 35

The rolling yield is the sum of the yield income and the rolldown return.

Yield income = Coupon / Opening Price

Rolldown return = (Closing Price - Opening Price) / Opening Price

Question 36

How do you calculate the return of a fixed income portfolio?

Answer 36

Sum of the following components:

Coupon income
Rolldown return
Impact of change in benchmark yield (roll down return)
Impact of change in spread
Impact of FX

Question 37

How often does a portfolio manager who uses interest rate immunisation have to rebalancing?

Answer 37

Interest rate immunization is not a buy-and-hold strategy because the portfolio will require frequent rebalancing to keep the portfolio Macaulay duration matched to its target duration.

Question 38

How do you calculate a bond’s return using duration and convexity?

Answer 38

(-ModDuration x Change in Yield) + (0.5 x Convexity x Change in Yield^2)

Question 39

In a high volatility environment, what will a bond portfolio manager look to maximise?

Answer 39

Convexity

In times of increased interest rate volatility, the relationship between bond prices and
yields becomes more non-linear relative to a low volatility environment. With positive
convexity, the expected return of a bond will be higher than the return of an identical duration, lower-convexity bond for the same interest rate change.

Question 40

What is money duration?

Answer 40

This is the PVBP valuation

Question 41

What is the duration of a short position in bond futures?

Answer 41

Negative