Fixed Income Flashcards
Eliminate Counterparty credit risk
- Counterparty credit risk is essentially absent from exchange-traded derivatives, such as futures contracts, and
- It can be essentially eliminated from over-the-counter derivatives, such as swaps, through inclusion of a Credit Support Annex.
When to minimize convexity
Minimizing the portfolio convexity (i.e., the dispersion of cash flows around the Macaulay duration) makes the portfolio closer to the zero-coupon bond that would provide perfect immunization.
Roll Down Return
- The roll down return is equal to the bond’s percentage price change assuming an unchanged yield curve over the strategy horizon.
- The roll down return results from the bond “rolling down” the yield curve as the time to maturity decreases.
- As time passes, a bond’s price typically moves closer to par.
Value Weighted FI Index and Leverage
Value-weighted indexes are tilted toward issuers with higher levels of debt. The more an issuer or sector borrows, the greater the tilt toward that issuer in the index. 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.
Horizon Matching
Horizon matching is a hybrid approach to liability-based mandates that combines cash flow matching and duration matching. Cash flow matching intends to match a short- to medium-term liability stream (charity donations for the first five years) to a stream of bond portfolio cash inflows. Duration matching further considers that the bond portfolio’s reinvestment risk and market price risk offset each other.
Methods of Leveraging FI Portfolio
The following methods of leverage may be used to increase portfolio returns relative to an unleveraged portfolio:
- futures contracts
- swap agreements
- structured financial instruments
- repurchase agreements, and
- securities lending.
Investment Grade Bonds vs. High Yield Bond
- Investment-grade bonds have lower credit and default risks than high-yield bonds and are more sensitive to interest rate changes and credit migration, which cause credit spread volatility.
- The much higher credit loss rate experienced with high-yield bonds results in an emphasis on credit risk and the market value of the position to evaluate high-yield risk.
Emerging Market Credit
Emerging market credit is characterized by a concentration in commodities and banking and government ownership of some entities. Additionally, uncertainty in creditor rights can lead to lower recovery rates and lower credit quality.
MBS & Interest Rate Volatility
Purchase mortgage-backed securities when expecting interest rate volatility to decrease. (Higher interest rate volatility leads to higher prepayment risk)
MBS bonds have negative convexity
Top-Down vs. Bottom-Up
- The key feature of a top-down approach is the assessment of the relative value
- The sector divisions used by a top-down investor are often broader than those used by a bottom-up investor
Option Adjusted Spread
The main shortcoming of OAS Is that it depends on assumptions regarding future interest rate volatility. Also, a bond with an embedded option is unlikely to realize the spread implied by the bond’s OAS; the realized spread will either be more or less than the OAS, depending on whether the option is actually exercised. For these reasons, OAS is a rather theoretical measure of credit spread. Despite these shortcomings, OAS is the most widely accepted measure of credit spread for comparing bonds with optionality and other features that generate uncertainty in the bonds’ cash flow.
Cash flow matching
- Cash flow matching has no yield curve or interest rate assumptions.
- Cash flows come from coupon and principal repayments that are expected to match and offset liability cash flows.
Classes of Liabilities
Multiple liabilities immunization requirements
- Match money duration (or BPV) of the asset and liability
- Asset convexity exceeds liability convexity (lowest convexity that exceeds liability convexity)
Single liability immunization requirement
- Have an initial market value that equals or exceeds the PV of the liability
- Match portfolio Macaulay Duration with horizon date
- Minimize convexity
Immunization
An immunization strategy aims to lock in the cash flow yield on the portfolio, which is the internal rate of return on the cash flows. … 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.
Requirements for Appropriate Benchmark
The use of an index as a widely accepted benchmark requires clear, transparent rules for security inclusion and weighting, investability, daily valuation, availability of past returns, and turnover.
Risk of IG Bonds vs. Risk of HY Bonds
Investment-grade bonds have lower credit and default risks than high-yield bonds and are more sensitive to interest rate changes and credit migration, which cause credit spread volatility. The much higher credit loss rate experienced with high-yield bonds results in an emphasis on credit risk and the market value of the position to evaluate high-yield risk.
Characteristics of Emerging Market Credit
- Concentration in commodities and banking and government ownership of some entities.
- Uncertainty in creditor rights can lead to lower recovery rates and lower credit quality.
Flattening vs. Steepening Yield Curve
Under a flattening yield curve, a barbell portfolio will outperform bullet portfolios or laddered portfolios.
Under a steepening yield curve, a bullet portfolio will outperform barbell portfolios or laddered portfolios.
Increasing (Decreasing) Curvature
Increasing (decreasing) curvature can happen in 2 ways:
Short end rates and long end rates go down (up), while the middle range remains constant, think of a straight line and then you pull down left and right, and the curvature increases then
Short and long end rates remain constant but the middle range goes up (down).
Long Condor vs Short Condor
- You want a long condor (long 2s and 20s, short 5s and 10s) when the yield has greater curvature or flattens.
- You want a short condor (short 2s and 20s, long 5s and 10s) when the curve steepens.
Carry Trades Characteristics
- Carry trades may or may not involve maturity mis-matches. Intra-market carry trades typically do involve different maturities, but inter-market carry trades frequently do not, especially if the currency is not hedged.
- Carry trades may involve only one yield curve, as is the case for intra-market trades. If two curves are involved, they need not have different slopes provided there is a difference in the level of yields between markets.
- Inter-market carry trades do not, in general, break-even, if each yield curve goes to its forward rates. Intra-market trades will break even if the curve goes to the forward rates, because by construction of the forward rates, all points on the curve will earn the “first-period” rate (that is, the rate for the holding period being considered). Inter-market trades need not break even unless the “first-period” rate is the same in the two markets. If the currency exposure is not hedged, then breaking even also requires that there be no change in the currency exchange rate.
- The primary driver of inter-market trades is anticipated changes in yield differentials. the capital gains/losses arising from yield movements generally dominate the income component of return (i.e., carry) and rolling down the curve.
Best Carry Trades
The best carry is obtained by lending long/borrowing short on the steepest curve and lending short/borrowing long on the flattest curve.
Empirical Duration
Empirical Duration is the calculation of a bond’s duration based on historical data rather than a preset formula, like effective duration does.
A bond’s empirical duration is often estimated by running a regression of its price returns on changes in a benchmark interest rate.
Both interest rate risk and credit risk impact price movements of corporate bonds.
Effective duration is not the best gauge for change in price when credit risk exists.
Empirical duration, since it observes actual historical price changes, better captures the interplay between interest rate risk and credit risk.
Drawbacks of tail risk management strategies
Portfolio diversification:
An investor may find it difficult to identify attractively valued investment opportunities that can protect against every tail risk that the investor foresees.
The use of portfolio diversification as tail risk protection may not fully achieve an investor’s objectives.
Tail risk hedging involving derivatives:
Tail risk hedging, like insurance, typically has a cost and therefore lowers portfolio returns if the tail risk event does not occur.
Some investors cannot use derivatives and therefore may be unable to hedge certain tail risks via derivatives.
Modified Duration
Risk of leverage
- Magnified losses
- Higher risk
- Forced liquidations
Back-Testing
Back-testing is a simulation of real-life investing. For example, in a standard monthly back-test, one can build a portfolio based on a value factor as of a given month-end—perhaps 10 years ago—and then track the return of this portfolio over the subsequent month.
The purpose of back-testing is to identify correlations between the current period’s factor scores, FS(t), and the next period’s holding period strategy returns, SR(t + 1).
