Fixed Income

Question 1

Fixed Income Benefits

Answer 1

1. diversification - low corr w/ eqty
2. regular cash flow
3. inflation hedge
   
   • inf linked protects coupon/ principal
   • floating coupon protects coupon

Question 2

Immunization

Answer 2

assets invested to meet liabilities; to min variability in r, replicating 0 coupon bond; need duration and convexity of A/L

1. cash-flow matching
2. duration matching
3. contingent immunization: actively manage surplus, immunization before surplus is neg
4. horizon match: ST liab = CF match, LT liab = duration match

Question 3

Total Return Mandates

Answer 3

target abs return to outpreform index; active return

1. pure indexing: little flexibility (bond selection)
2. enhanced indexing: some flexibility
3. active management: more flexibility

Question 4

Bond Liquidity

Answer 4

1. little hist pricing data: use matrix pricing
2. act managers pref more liquid bonds (lower YTM)
3. bonds are heterogeneous
4. OTC: need to find counterparty
5. quality

Question 5

Bond Return

Answer 5

1. yield on income: annual coupon/ bond price
2. rolldown return: (proj ending/ beg price) - 1
3. manager pred Δ price: -D(Δr) + ½C(Δr²)
4. credit losses
5. currency g/l

Question 6

Rolling Yield

Answer 6

yield income + rolldown return

Question 7

Leverage

Answer 7

using borrowed funds to purchase assets

r_lev = r_i + [( V_borrowed/ V_eqty )*( r_i- r_b )]

risk: Δ in value collateral and r_i - r_b

Question 8

Ways to Achieve Leverage

Answer 8

1. repo
2. futures
3. swaps
4. structured finance inst
5. sec lending

Question 9

Duration Matching

Answer 9

• PVA > PVL
• D_A = DL (single liab)
• BPV_A = BPV_L (multi liab)
• min convexity

NO PASSIVE - rebalance regularly

Question 10

Convexity

Answer 10

magnifies the upside and reduces the downside of price movement b/c changes in rates

Question 11

Duration Gap

Answer 11

|BPV_A - BPV_L|

BPV_{A or L} = Duration * Value * 0.0001

Question 12

Futures Contracts Req to Close Duration Gap

Answer 12

N_{futures cont} = duration gap / BPV_futures

BPV_futures = BPV_CTD/ CF_CTD

contracts = ( ΔD / D_f ) * ( V_p / V_f )

Question 13

Closing Duration Gap with Swap

Answer 13

NP = ΔBPV/ BPV_swap

BPV_swap = BPV_rec - BPV_paid

Question 14

Swaption

Answer 14

option to enter a swap, pay premium

• payer swaption: SFR_swaption < SFR_new; exercise
• rec swaption: SFR_swaption > SFR_new; exercise

Question 15

Spread Risk

Answer 15

spread changes → rates cannot match; PV may not change as expected

example: portfolio yield and liab discount rate differ → diff risk levels

Question 16

Controlling Risk of FI Bonds

Answer 16

• match modified duration: control for parallel shifts of yield curve
• match key rate duration: control for nonparallel shift of yield curve
• match weighting to diff sectors and ratings
• matching issuer exposure: control for firm specific event risk

Question 17

Portfolio Structures

Answer 17

• bullet: conc in single middle duration
• ladder: equal par amounts purchased, come due each year
• barbell: conc in shorter and longer duration

Question 18

Cell Matching

Answer 18

matching the primary risk factor (duration) of the benchmark to minimize tracking error

Question 19

ETF

Answer 19

exchange traded fund

PROs: inc liquidity, price stability in maturing ETFs, inc convexity

Question 20

Stable Yield Curve Strategies

Answer 20

1. buy and hold
2. ride the yield curve: buy and sell, repeat
3. carry trade
4. sell convexity: buy/ sell options

Question 21

Parallel Shifts in Yield Curve Strategies

Answer 21

• inc rates: dec duration
• large movement: inc convexity (buy calls and puts, sell callable/ buy putable bonds, barbell portfolio)

Question 22

Nonparallel Shifts in Yield Curve Strategies

Answer 22

• flatten: inc duration; barbell
• steepen: dec duration; bullet

Question 23

Spreads

Answer 23

• g-spread: YTM_b - YTM_{OTR gb}
• i-spread: YTM_b - YTM_swap
• z-spread: added to r_f to get PVCF = price
• OAS: z-spread for options

Question 24

Excess Return

Answer 24

s*t - Δs*D_spread - t*p*L

L = loss severity