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Fina 385: Theory of Finance 1 > investment strategies and shit > Flashcards

investment strategies and shit Flashcards

1
Q

A passive investment strategy

A

assumes that market prices of securities are fairly priced

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2
Q

who tries to maintain an appropriate risk exposure OR simply replicate the return of the market (Bond market index)

A

Passive managers

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3
Q

Immunization

A

type of passive investment strategy that tries to hedge a portfolio against interest rate risk

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4
Q

what creates interest rate risk

A

the sensitivities of bonds’ prices to interest rates’

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5
Q

An active investment strategy

A

tries to achieve abnormal returns (returns in excess of the risk taken)

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6
Q

two ways to achieve an active investment strategy

A

Relying on interest rates (IR) forecasts to predict bond movements

Looking for mispriced bonds

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7
Q

bond market risk

A

Bond prices fluctuate as interest rates fluctuate

This up or down movement in the prices of bonds creates a risk that bonds’ investors have to face

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8
Q

Bond pricing relationships (properties)

A
  1. Bond prices and yields are inversely related

–> As yields increase, bond prices fall and vice versa

  1. An increase in bond’s yield to maturity results in a smaller price change than a decrease in yield of equal magnitude.
  2. Prices of long-term bonds tend to be more sensitive to IR changes than prices of short-term bonds

–> Cash flows are discounted at higher rates)+

  1. The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases

–> IR risk is less than proportional to bond maturity

  1. IR risk is inversely related to the bond’s coupon rate

–> Prices of low coupon bonds are more sensitive to changes in IR than prices of high coupon bonds

  1. The sensitivity of a bond’s price to a change in its yield is inversely related to the yield to maturity at which the bond currently is selling.
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9
Q

why do Zero-coupon bonds have a well-defined time to maturity?

A

no payments until maturity

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10
Q

how do Coupon paying bonds apply Effective Maturity?

A

Average of all the maturities of all promised cash flows

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11
Q

Duration or (Macaulay Duration)

A

a measure that proxies the sensitivity of a bond to interest rate risk

–> The higher the bond’s duration, the higher the sensitivity of the bond to interest rate risk

approximates the sensitivity of the bond to interest rate risk

Price change is proportional to duration

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12
Q

duration of a coupon paying bond

A

the weighted average of the time to receive all payments (each coupon and principal payment made by the bond)

D = E(t · wt)

wt = (CFt / (1 + y)^t) / bond price

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13
Q

duration of a zero-coupon bond

A

its time to maturity

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14
Q

the modified duration

A

to estimate bond’s price movements relative to movements in bond’s YTM

D* = D / (1 + y)

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15
Q

The percentage change in bond’s price relative to changes in the bond’s YTM formula using the modified duration

A

(Delta P) / P = -D*(Delta y)

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16
Q

Bond’s Duration is affected by which three major factors?

A

Bond’s time to maturity

Bond’s coupon rate

Bond’s yield to maturity

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17
Q

Duration has the which four major properties?

A
  1. The duration of a zero coupon bond is equal to its maturity
  2. Holding maturity constant, a bond’s duration is higher when the coupon rate is lower
  3. Holding coupon rate constant, a bond’s duration generally increases with bond’s maturity.

–> Duration always increases for bonds selling at par and at a premium

–> Duration does not always increase for bonds selling at a discount!

  1. Holding other factors constant, the duration of coupon bond is higher when the bond’s YTM is lower
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18
Q

The duration of a perpetuity (infinitely lived bond) is equal to

A

D = (1 + y) / y

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19
Q

the bond convexity

A

it shows how bond prices change (decrease) as a interest rates change (increase)

–> it shows that it is not a linear function

–> the higher the interest rates, the less prices will drop the more interest rates rise

–> the lower the interest rates, the more prices will drop the more interest rates rise

the rate of change of the slope of the price-yield curve,
expressed as a fraction of the bond price

The higher the convexity of the bond, the higher the curvature in the price-yield curve

20
Q

convexity formula

A

(1 / (P · (1 + y)^2)) · E((CFt/(1 + y)^t) · (t^2 + t))

21
Q

Convexity correction

A

allows us improve the duration approximation

22
Q

why is convexity desired by investors

A

because it increases the price of bonds whether YTM increases or decreases

–> If the bond convexity is positive, then the second term of its formula is positive as well and it will add to the price of the bond whether interest rates increase or decrease

–> If interest rates increase, the price of a bond with larger convexity will decrease less than that with lower convexity

–> If interest rates decrease, the price of a bond with larger convexity will increase more than that with lower convexity

23
Q

which two classes of passive bond management are generally taken by investors?

A

Indexing strategy

Immunization strategy

24
Q

Indexing strategy

A

attempts to replicate the performance of a given bond index

An index bond portfolio would have the same risk-reward profile as the index to which it is tied

25
Q

Immunization strategy

A

attempts to protect the firm from the exposure to interest rates fluctuations

An immunized bond portfolio would have almost zero market risk; in the sense that any fluctuations in interest rates would not affect the bond portfolio value

26
Q

Several challenges facing bond index portfolio formation

A

bond indices include very large number of bonds (around 5,000 in the US)

many bonds are thinly traded (especially in Canada)

–> fair market pricing is difficult

Bonds generate continuous income (the coupons) that need to be invested

Frequent rebalancing of their bond portfolios to accommodate the changes in the constituents of the bond index:

–> • Bonds are dropped from the index as their maturity is less than one year

–> • New bonds are issued need to be added to index

27
Q

is it feasible to precisely replicate a bond index?

if not, what do we do instead

A

nah bruv

A stratified sampling approach is followed by bond investors instead

28
Q

A stratified sampling approach

A

They only hold a representative sample of the bonds in the actual index

  1. Divide the universe of bonds into several categories:

–> Maturity

–> Issuer Credit

–> Risk Coupon rate

  1. Each category is further divided in several divisions

–> Any bond should be associated with one division of every category

–> Subdivisions are formed containing the pool of bonds associated with them

–> Bonds falling within each subdivision are considered homogeneous

  1. Estimate the percentage of the whole bonds universe falling within each subcategory
  2. Establish a bond portfolio by selecting few bonds from each subcategory on condition that you keep the percentage weights of each category in your portfolio similar to that of the index
29
Q

explain the mismatch between the maturity of asset and liabilities for banks?

what then happens if interest rates rise unexpectedly?

A

Banks have short term liabilities and long term assets

If IR rise unexpectedly then Bank suffers serious decrease in net worth since

–> Assets fall in value by more than the liabilities

30
Q

explain the Pension funds’ mismatch between IR sensitivity of assets held in the fund and the PV of its liabilities

how do they do their immunization?

A

As IR drop the value of liabilities grow even faster than the value of their assets

–> objective is to make value of assets track the value of liabilities if IR increase or decrease

Liabilities of Pensions is long-dated meaning they need to match assets duration to liabilities duration

–> They invest in alternative assets with long durations like real-estate and infrastructure

basically, they get a bond at a certain interest rate so that the future values of cashflows and the future PV of the sale of the bond equal the long term liabilities

–> if interest rate decreases, the future value of cashflows decrease, but the future value of the sale of the bond will increase offsetting the former effect

–> if interest rate increases, the future value of cashflows increase, offsetting the future value of the sale of the bond decreasing

–> in the end, wether an increase or decrease, they can still pay their long term debts

we make sure we hold the bond until we owe our debts

more effective in small changes in interest rates

31
Q

Immunization protect investors against which two types of risks?

A

Price risk

Reinvestment rate risk

32
Q

Once index bond managers immunize a portfolio, why do portfolio managers have to rebalance the portfolio?

A

As time goes on, interest rates change leading to new duration for both assets and liabilities

–> These need to be re-matched

As time goes on, the duration of assets and liabilities changes

–> This triggers a rebalancing to re-match both assets duration and liabilities duration

33
Q

true or false

once a duration based immunization is adopted, the net worth of the portfolio is protected from interest rate risk at that point in time only

A

true

Time passage and other factors affect the durations of assets and liabilities and a manager must rebalance the portfolio fixed-income assets continuously to realign its duration with the duration of the obligations

Without rebalancing, the durations will become unmatched and the immunization’s objective is not reached

34
Q

why is continuous rebalancing is not feasible?

A

It requires continuous resources

It costs a lot due to transaction costs

–> as a result, a compromise is usually adopted to balance between the accuracy of the immunization techniques and the rebalancing costs

—-> Chose imperfect immunization over trading costs

35
Q

a Dedication Strategy

A

Cash Flow Matching on a multi-period basis

to match a series of obligations to a selection of either zero-coupon or coupon bonds

it eliminates the need for rebalancing

not always possible to do

36
Q

why is it not always possible to do Cash Flow Matching?

A

If we are facing perpetual obligation (like retirees of pension funds), we cannot find zero-coupon bonds with hundreds of years of maturities

–> It would be infeasible

37
Q

Duration based immunization

A

relies on duration estimates

–> strictly valid only for a flat yield curve

–> where all payments are discounted at a common IR

—-> not always correct as spot rates vary

38
Q

do we need to consider inflation in immunization strategies?

A

yeee

39
Q

the two possible sources of potential profit for active bond managers?

A

Proper forecasting of the interest rates fluctuations

Successful identification of mispriced fixed income securities

40
Q

Homer and Liebowitz identified which four types of bond swaps that bond portfolio managers follow in their attempt to actively manage a portfolio?

A

The substitution Swap

The Intermarket Spread Swap

The Rate Anticipation Swap

The Pure Yield Pickup Swap

41
Q

the two possible sources of potential profit for active bond managers?

A

Proper forecasting of the interest rates fluctuations

Successful identification of mispriced fixed income securities

–> A positive abnormal return based on such strategies is highly linked to the accuracy of the managers’ information or insights

42
Q

Homer and Liebowitz identified which four types of bond swaps that bond portfolio managers follow in their attempt to actively manage a portfolio?

A

The substitution Swap

The Intermarket Spread Swap

The Rate Anticipation Swap

The Pure Yield Pickup Swap

43
Q

The Substitution Swap

A

an investor swaps one bond with another having the same characteristics (equal coupon, maturity, quality, and other possible features) because these bonds have non-justified differences in prices

Such a swap would be motivated by a belief that the discrepancy between the bonds is a mispricing and it represents a profit opportunity

44
Q

The Intermarket Spread Swap

A

In an intermarket swap an investor swaps, for example, one 20 year government with another 20 year Baa corporate bond

would be motivated by a belief that the yield spread (difference between the yields) between two sectors of bonds is temporarily out of line

45
Q

The Rate Anticipation Swap

A

an investor swaps bonds with longer duration with
those of shorter duration and vice versa

motivated by an anticipated increase (decrease) in interest rates

–> if interest rates are expected to decrease, an investor will swap the short term two government bonds with the longer term 20 years government bonds

–> The latter have higher duration and will have a greater increase in their prices than the short term one

46
Q

The Pure Yield Pickup Swap

A

an investor swaps a bond with higher YTM with
one having a lower YTM

motivated by the assumption that interest rates will not move during the life of the swap

–> An investor in this swap is ready to bear the interest rate risk

Fina 385: Theory of Finance 1 (12 decks)

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