Lecture 13

Question 1

Passive managers take bond prices as

Answer 1

Fairly set. Seek to control only risk fixed income portfolios

Question 2

Passive bond portfolio strategies (2)

Answer 2

• Indexing

- Immunisation

Question 3

Bond-index portfolio has same risk-reward profile as

Answer 3

Bond market index to which it is tied

Question 4

Immunisation strategies seek to

Answer 4

Establish virtually zero-risk profile in which interest rate movements have no impact on the value of a firm

Question 5

Bond index funds create

Answer 5

Portfolio that mirrors the composition of an index that measures the broad market

Question 6

Bond index funds buy shares

Answer 6

In each firm in index in proportion to the market value of outstanding equity

Question 7

Bond index fund problems (4)

Answer 7

• Contain numerous issues, many infrequently traded
• Difficult to purchase each security in proportion to market value
• Rebalancing problems > bonds continually dropped/ added to index
• Bonds generate interest income > must be invested > complicated job of fund manager

Question 8

It is infeasible to precisely replicate a broad bond of indexes therefore

Answer 8

Stratified sampling/ cellular approach is taken

Question 9

Immunisation aims to

Answer 9

Insulate portfolios from interest rate risk altogether

Question 10

In immunisation, investors are more concerned with

Answer 10

Protecting the future value of portfolios

Question 11

Many banks have natural mismatch between

Answer 11

Asset and liability maturity structures

Question 12

When interest rates change

Answer 12

Assets change in value more than liabilities

Question 13

Immunisation seeks to match

Answer 13

Interest rate exposure of assets and liabilities by matching their duration, and ensuring the price and reinvestment risk exactly cancel out

Question 14

Two types of interest rate risk

Answer 14

• Price risk

- Reinvestment rate risk

Question 15

Price risk =

Answer 15

Risk that interest rates will rise, and bond prices fall

Question 16

Reinvestment rate risk =

Answer 16

Risk of a change in coupon payment

Question 17

Increases in interest rates cause (2)

Answer 17

• Capital losses
• Increase rate at which reinvestment income grows
  If portfolio duration is chosen appropriately, the two effects can cancel out exactly

Question 18

Horizon date =

Answer 18

Portfolio’s duration

Question 19

Rebalancing =

Answer 19

Realigning the proportion of assets in a portfolio as needed to realign the duration with that of the obligation

Question 20

Immunisation is a passive strategy because

Answer 20

It does not involve attempts to identify undervalued securities

Question 21

Sources of potential value of active bond management (2)

Answer 21

• Interest rate forecasting

- Identification of relative mispricing

Question 22

Interest rate forecasting =

Answer 22

Anticipate movements across the spectrum of fixed income market. If interest rates fall, managers increase the portfolio duration

Question 23

Identification of relative mispricing

Answer 23

Within the fixed income market

Question 24

Portfolio rebalancing activities

Answer 24

Bond swaps

Question 25

Substitution swap =

Answer 25

Exchange bond for nearly identical substitute (motivated by belief tat the market has temporarily mispriced the two bonds)

Question 26

Intermarket spread swap =

Answer 26

Pursued when the investor believes the yield is spread between two sectors’ bond markets is temporarily out of line

Question 27

Rate anticipation swap =

Answer 27

Pegged to interest rate forecasting. If the investor believes rates will fall, they will swap into longer duration bonds

Question 28

Pure yield pick up swap =

Answer 28

Increasing return by holding higher yield bonds. When the yield curve is upward sloping, the yield pick up swap entails moving into longer-term bonds to earn a high rate of return

Question 29

Tax swap =

Answer 29

Swap to exploit some tax advantage