Lecture 2 Flashcards
For an investment bank the trading book is market-to-market
daily
For an investment bank, large drops in value of the trading book can cause
Loss of shareholder wealth, and knock on effects such as a
regulatory capital deficiency
how does term to maturity affect interest rate sensitivity
long term bonds are more sensitive to interest rate changes due to higher uncertainty of the future of the economy
how does the coupon rate affect interest rate sensitivity
high coupon bonds are less sensitive as the interest rate doesn’t matter as much
how does bond yield affect interest rate sensitivity
low yield bonds are more sensitive because a good bond is more adversely affected by interest rate changes
Define duration
- Duration measures sensitivity to yield changes
- Duration measures the average time the investor
receives his cashflows - A bond with a greater duration receives its cashflows
later and therefore is more sensitive to changes in the yield
what does the yield curve measure
yields against maturity
discuss the usefulness of the duration measure when dealing with portfolios
The duration of a portfolio of bonds is value weighted sum of the
durations of the individual assets in the portfolio.
However when applied to a portfolio of bonds there is an implicit
assumption that the yields of all the bonds have changed by the same
amount dy. i.e. a parallel shift in the yield curve
can we assume that changing the yield, will cause a parallel shift in the yield curve
Yes, subject to conditions
many changes are parallel but not all
limitations of the duration model
- assumption of parallel shifts in the yield curve does not always hold (reasonable assumption in the short term)
- method is only accurate for small changes in yields
how do we duration match
the firm makes sure that (duration of assets)(value of assets) is equal to (duration of liabilities)(value of liabilities)
– If a firm does this then it is immunised against changes in yields:
where are treasury bond futures contracts traded
Exchange traded contract (CBOE)
usually traded as a long term (15 years)
what is a swap
An agreement to exchange one stream of cash flows for another
One party pays a cashflows stream to the other party and receives a
cashflows stream from that party
Vanilla interest rate swap
- One party swaps floating rate payments for fixed rate
payments. - The other party swaps fixed rate payments for floating
rate payments
where are interest rate swaps traded
OTC
usefulness of swaps
Swaps are uniquely suited to changing the risk exposure to a stream of cashflows
Swaps are equivalent to a package of derivative
convenient and cheap
what is the motivation for firms to hedge away interest rate and exchange rate risk
By hedging away risk, firms can be more certain of future outcomes, reducing their exposure to large financial losses and financial distress
what determines the difference between LIBOR and treasury rates
LIBOR is the global benchmark representing the average rare major international banks can borrow from each other in the short term
the difference arises due to the credit risk of different banks
which yield curve is most common
increasing
as maturity increases, unpredictability of the evolution of the economy creates unpredictable risk
What does a downwards sloping yield curve imply
the economy is going to improve overtime
What is the dollar maturity gap
the amount of assets re-priced over a certain period (RSA)
minus the amount of liabilities re-priced over the same period (RSL)
RSA > RSL positive maturity gap and the firm is asset sensitive and will gain if interest rates increase
