MIP 6 - Fixed Income Portfolio Management Flashcards

1
Q

What are the 4 key activities in the investment management process?

A
  1. Setting the investment objective (return, risk, and constraints)
  2. Developing and implementing a portfolio strategy
  3. Monitoring the portfolio
  4. Adjusting the portfolio
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2
Q

List the 5 strategies for managing FI portfolio against a bond market index, from the least tracking error to most

A
  1. Pure bond indexing (or full replication)
    • Attempts perfect match (own all bonds in index)
  2. Enhanced indexing by matching primary risk factors
    • ​​Primary risk factors: interest rate level, yield curve twists, and spreads
  3. Enhanced indexing by small risk factor mismatches
    • Match duration, while actively managing smaller risk factors (sector, quality, term structure etc.)
  4. Active management by larger risk factor mismatches
  5. Full-blown active management (most aggressive mismatches)
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3
Q

Describe disadvantages of Pure Bond Indexing in FI portfolio management

A
  • Very difficult and rarely done in practice
  • Expensive and inefficient
  • Many bonds in an index are illiquid and rarely traded
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4
Q

Describe advantages of Enhanced Indexing by matching primary risk factors in FI portfolio management

A
  • Lower cost than pure indexing – uses only a sample of the bonds in the index
  • Still affected by broad market events (due to primary risk factor match)
  • Manager can enhance yield by selecting under-valued bonds
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5
Q

Describe disadvantages of Enhanced Indexing by matching primary risk factors in FI portfolio management

A

more tracking error with the index

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6
Q

List the 3 reasons for using indexing

A
  1. Lower fees than managed accounts
  2. Outperforming an index (after costs) is difficult to do consistently
  3. Excellent diversification
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7
Q

Describe the risk factors to consider when choosing an index (in pure and enhanced FI strategies)

A
  1. Market value risk of portfolio should be similar to benchmark
    • Longer portfolios tend to have higher MV risk (higher sensitivity to interest rate changes)
  2. Income risk should be similar to benchmark
    • Longer portfolios tend to have less income risk (more stability)
  3. Liability framework risk – should match A/L investment characteristics
    • Use longer bonds for longer liabilities
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8
Q

Yield Curve Risk Factors (indexing FI strategies)

A

Yield curve = major source of risk for most bonds

  1. Parallel shifts account for 90% of bond value changes
  2. Twists (points move in different directions)
  3. Other curvature changes
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9
Q

Describe the 3 risks when assessing an index’s
sensitivity (indexing strategies)

A
  1. Interest rate risk – changes in level of interest rates (parallel shifts)
    • Largest risk source (90%)
  2. Yield curve risk – changes in yield curve shape (twists, curvature)
  3. Spread risk – changes in spread over Treasuries (credit risk)
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10
Q

Cell-matching a.k.a. stratified sampling Indexing (Pure and Enhanced)

A

divides the benchmark into risk cells

  • Manager chooses bonds from each cell to match the overall index
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11
Q

Multi-factor model Indexing (Pure and Enhanced)

A

makes use of a set of factors that drive bond returns

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12
Q

List the primary bond risk factors.

A
  1. Duration and convexity – price sensitivity to parallel yield shifts
  2. Key rate duration and present value distribution of cash flows
  3. Sector and quality percent
  4. Sector duration and contribution
  5. Quality (credit) spread duration contribution
  6. Sector/coupon/maturity cell weights
  7. Issuer exposure (manage event risk)
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13
Q

Definition and challenge of Effective duration

A
  • Measures the linear (first order) sensitivity to small parallel shifts in interest rates
  • Problem: Perfectly parallel shifts in the yield curve are rare
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14
Q

Convexity adjustment

A

Estimates additional price change due to larger yield curve shifts that comes from curvature (second order effects)

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15
Q

Key rate duration

A

Measures the sensitivity to a small change in a single key rate

  • Hold all other rates on the yield curve constant except one
  • Useful for testing bulltet and barbell strategies
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16
Q

Present value distribution of cash flows (Primary bond risk factors) and formula

A
  • Measure sensitivity to non-parallel yield curve changes
  • This approach is basically matching the portfolio’s KRDs to the index (i.e. weighting each KRD by the PV of cash flows for that key rate)
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17
Q

When is Sector/coupon/maturity cell weights more feasible than convexity matching

A

when call exposure is a concern

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18
Q

Describe tracking risk and its formula components

A

standard deviation of the portfolio’s active return over time

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19
Q

Describe the main disadvantage of using enhanced bond management strategies

A

add costs –> must be earned on top of a passive return

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20
Q

Describe strategies to overcome the high costs of enhanced indexing

A
  1. Lower cost enhancements – reduce trading costs and management fees
  2. Issue selection enhancements – attempt to find undervalued securities
  3. Yield curve positioning – find consistently mispriced maturities
  4. Sector and quality positioning (2 forms)
  5. Call exposure positioning – e.g. under-weight in callable bonds if you expect falling interest rates
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21
Q

Two strategies of Sector and quality positioning to overcome high costs of enhanced indexing

A
  • Tilt toward short duration corporates
    • offer best yield spread per unit of duration risk
  • Periodic over- or under-weighting of sectors or qualities
    • over-weight on Treasuries if spreads are expected to widen
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22
Q

Describe some additional activities that are carried out by active FI managers

A
  1. Exploit index mismatches (based on manager’s expertise)
  2. Extrapolate market expectations from market data (e.g. analyze forward rates)
  3. Independently forecast inputs (interest rates, volatility, spreads, etc.) and compare with market’s expectations
    • Example: manager may believe forward rates are too high -> increases duration mismatch by increasing portfolio duration
  4. Estimate relative values of securities to identify areas of under- or over-valuation
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23
Q

Define total return with respect to bond returns and list one shortcoming

A
  • takes into account coupon income, reinvestment income, and change in price
  • A simple total return estimate does not reflect the risk of being wrong (since it’s only one scenario)
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24
Q

Formula and specifications of total return with respect to bond returns

A

manager must specify the investment horizon, expected reinvestment rate, and expected future price to calculate the total return

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25
Q

Describe the purpose and benefits of scenario analysis.

A

should be performed to see returns under different sets of assumptions

  1. Assess distribution of possible outcomes (wider distribution = more risk)
  2. Reverse scenario analysis: determine the interest rate movements that would trigger acceptable outcomes
  3. Calculate contribution of individual components (e.g. impact of a yield twist)
  4. Evaluate merits of entire trading strategy
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26
Q

How do amount and timing of liabilities impact FI portfolio strategy?

A

The more unknown the amount or timing of liabilities, the less effective passive strategies are (i.e. active management is needed)

  • For a typical life or annuity product, the amount of the liability will be known, but the timing will not.
  • However, certain products have unknown amounts and timing (e.g. a VA GMDB).
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27
Q

FI dedication strategies

A

Specialized fixed-income strategies designed to accommodate specific
funding needs of an investor

  • Includes immunization and cash flow matching
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28
Q

List extensions of Classical single period Immunization

A
  1. Extensions for non-parallel shifts
  2. Relax the fixed horizon requirement
  3. Return maximization (risk and return trade-offs)
  4. Contingent immunization
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29
Q

Describe Immunization strategies

A
  • Lock in a rate of return over a specified horizon regardless of interest rate changes
    • Price changes offset with reinvestment income changes
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30
Q

Classical Single-Period Immunization and important Characteristics

A

Results in a fixed-income portfolio that produces an assured return for a specific time horizon

  1. Specified time horizon
  2. Assured rate of return over a fixed holding period
  3. Insulation from the effects of interest rate changes on the portfolio value at the horizon date
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31
Q

List extensions of Cash Flow Matching

A
  1. symmetric
  2. combination (horizon) matching
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32
Q

List the 2 requirements for classical single period immunization

A

Requires offsetting price risk and reinvestment risk

  1. Portfolio duration = liability horizon (duration)
  2. PV of portfolio cash flows = PV of liability cash flows
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33
Q

Does investing in a coupon bond matching liability yield and horizon guarantee that the liability will be met?

A

No…because the bond’s duration will be shorter than the liability

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34
Q

Describe 2 ways that a portfolio’s duration can change that will require rebalancing an immunized portfolio

A
  1. As market yields change (convexity effects)
  2. With the passage of time (duration naturally falls as the bond approaches maturity
  3. Also if the liability duration changes

Key point: an immunized portfolio must be continually rebalanced to stay duration-matched

  • Must balance transaction costs of rebalancing with the risk of duration mismatches
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35
Q

Define the immunized target rate of return.

A

total portfolio return assuming no change in the term structure

Will only equal YTM if the yield curve is flat
If yield curve is positively sloped, total return < YTM
If yield curve is negatively sloped, total return > YTM

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36
Q

Dollar duration (DD) and portfolio DD

A
  • Change in portfolio value (price) for a 100 bps change in yield
  • Portfolio Dollar Duration = Portfolio Duration * Portfolio Value * 0.01
  • Also simply the sum of the individual bonds’ DD
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37
Q

Bond Duration and Portfolio duration

A
  • % change in bond price P for a 100 bps change in yield
  • For example, a bond has duration of 5, it means that the bond’s price will fall 5% if there is a 1% parallel increase in yield curve.
  • The duration of a portfolio = price-weighted average of the individual bonds’ durations
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38
Q

Formula for portfolio duration

A
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39
Q

Formulas for Macauley and Modified duration

A
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40
Q

Describe the steps required for rebalancing to the desired level of dollar duration.

A
  1. Calculate the new (or current) portfolio DD
  2. Calculate the rebalancing ratio:
    • Target DD /New DD - 1
  3. Calculate amount of cash needed for rebalancing:
    • Rebalancing Ratio * MV of Portfolio
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41
Q

what does a rebalancing ratio = 10% mean?

A

it means each position in the portfolio should be increased 10%
get back to the target (or original) DD based on the new yield curve

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42
Q

Controlling position in portfolio rebalancing

A

A particular security in the portfolio that is used to control the portfolio’s DD

  • Instead of applying a rebalancing ratio to all positions, calculate the adjustment needed for a single position
  • Derivatives can also be used (covered later)
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43
Q

Define spread duration.

A

measures the change in market value of a risky bond if spread changes by 100
basis points

  • mainly applicable to bonds/portfolios with credit risk (credit spreads)
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44
Q

3 major types of spread that can be used for spread duration

A
  1. Nominal spread – spread above the yield of a certain maturity Treasury
  2. Static spread (zero-volatility spread) – constant spread above the Treasury spot curve such that PV cash flows = current price
  3. Option-adjusted spread (OAS) – current spread over the benchmark yield minus the portion attributable to the embedded options
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45
Q

Compare and Contract OAS and static spread durations

A
  • OAS is like the static spread, but solved for stochastically so that the effect of embedded options is properly reflected.
    • Callable bond will only be called in down scenarios
    • Stochastic analysis could capture those scenarios, not just the current yield curve
  • OAS is less then static spread, reflecting the possible lost yield in future down scenarios
  • However, callable bonds still have higher yield spread than non-callable bonds of the same maturity, to compensate for call risk
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46
Q

Portfolio spread duration

A

market weighted average of each bond’s spread duration

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47
Q

Describe limitations of Classical single-period immunization assumptions

A

Assumptions:

  1. Interest rates move in parallel (most critical assumption)
  2. Fixed horizon date without any interim cash flows before the horizon date
  3. Target value = lower limit of the portfolio value at the horizon date if the yield curve shape (structure) does not change (i.e. no non-parallel shifts)

most interest rate shifts are non-parallel, interim cash flows are common, and the term structure is likely to change before the horizon date

48
Q

Describe how classical immunization can be extended for non-parallel interest rate shifts of yield curve

A
  • Multi-functional or functional duration – a.k.a. key rate duration
  • Immunize against an arbitrary interest rate change subject to the constraint that Portfolio Duration = Investment Horizon
    • Changes in portfolio value depend on:
      1. Structure of investment portfolio
      2. M2 = immunization risk measure (“maturity variance”)
49
Q

M2 Immunization Risk Meausre for non-parallel interest rate shift

A

M2 = immunization risk measure (“maturity variance”) describes nature of interest rate shock:

  • If M2 is small, immunization risk is small
50
Q

Describe the steps under multiple liability immunization

A
  1. Set asset portfolio duration = liability duration
  2. Asset cash flows have higher dispersion than liability cash flows
    • must “bracket” liability cash flows
    • Distribution of individual asset durations is wider than the distribution of individual liability durations
    • Shortest asset < shortest liability; longest liability < longest asset
51
Q

Describe a problem with multiple liability immunization

A

Still exposed to non-parallel shifts

52
Q

Describe the issues that require immunizing general cash flows

A
  • Previous immunization methods have assumed all assets are invested at time zero
  • There are often situations where some of the assets won’t be available until a future date
53
Q

Describe the steps for immunizing general cash flows

A
  1. Assume future assets are a hypothetical investment maturing before liab horizon
  2. Invest available funds to mature after liability horizon
    • Weighted avg duration (incl hypothetical assets) should match liability horizon
  3. When the future assets become available:
    • Invest new funds in assets that will mature at the liability horizon
    • Sell existing longer assets and reinvest at the liability horizon
54
Q

Impact of Immunization for General Cash Flows on interest rate risk (non-parallel shifts)

A
  • Any change in interest rates will have offsetting effects on each asset balance at the reinvestment date
  • E.g. interest rates fall, the longer assets will have a capital gain even though the new funds will be invested at a lower rate
55
Q

What is the goal of return maximization for immunized portfolios?

A

maximize the lower bound return given the investor’s risk tolerance

  • Expected Return +- 2 standard deviations (2 is an approx for 1.96 for 95% CI)
56
Q

Example of Expected Active porfolio return vs Expected Immunized return

A
  • Suppose the immunized return available is 8% with 10 bps volatility:
    • Lower bound = 8.00% - 0.20% = 7.80%
  • But suppose an active portfolio has an expected return of 8.30% with 15 bps volatility
  • Lower bound = 8.30% - 0.30% = 8.00%
  • The active portfolio’s return will exceed the expected immunized return 97.5% of the time
    • An investor may be comfortable with taking more liability funding risk to achieve a higher return
57
Q

When is contingent immunization possible?

A
  • When the available immunized return (i) > required rate of return to reach terminal value (“safety net rate of return,” s)
    • Cushion spread = max (0,i-s)
  • Pursue active management as long as there is a positive safety margin
    • Safety margin = current portfolio value - Min value required for Immunization
  • Thus, immunization is a fall-back strategy if the actively managed portfolio does not grow at a certain rate
58
Q

Initial minimum portfolio value required for (contingent) immunization

A

s and i are bond-equivalent (semiannual) yields above (but don’t have to be)

59
Q

Example of contigent immunization

A

For example, if a portfolio’s required rate of return is s = 3%, contingent immunization is possible as long as the portfolio can be immunized at a rate of return greater than 3%

  • This is because the portfolio value is worth more than the investment needed to mature the portfolio
  • The investment manager could then actively manage part of all of the portfolio

If the actively managed portfolio’s value ever falls to the minimum required for immunization in the future, the portfolio should be immunized immediately (because the safety margin would be zero)

60
Q

Describe the sources of liability funding risk

A
  1. Interest rate risk – reinvestment and disintermediation risk
  2. Contingent claim risk (call and prepayment provisions)
    • Call/prepayment features add reinvestment risk
  3. Cap risk (floating rate securities with caps)
    • If market rates rise above the cap, investor foregoes additional interest and bond behaves like a fixed bond
61
Q

Bullets vs. barbells (immunized portfolios)

A
  • Barbell portfolio – made up of short and long maturities relative to the horizon date and interim coupon payments
  • Bullet portfolio – the bond maturities are very close to the investment horizon
  • Both strategies can be immunized against parallel interest rate shifts (both can be constructed to have the same duration)
  • Barbells are more exposed to non-parallel shifts
  • Bullet strategies are less risky
62
Q

Describe the differences between cash flow matching and multiple liability
immunization.

A
  • • Main problem with cash flow matching:
    • Exact matching is usually not possible
    • Reinvestment will be required = liability funding risk
  • Cash flow matching is inferior to multiple liability immunization because it requires:
    • Relatively high cash balance with a conservative rate of return
    • Funds available when or before each liability is due
  • Cash flow matching is still used sometimes because it is easy!
63
Q

Cash flow matching execution

A

Match the last liability cash flows first, and then work down to the first cash flow

64
Q

Describe the importance of reinvestment risk for immunization risk

A

Portfolios with the least reinvestment risk have the least immunization risk

65
Q

Describe the 2 extensions of basic cash flow matching

A
  1. Symmetric cash flow matching
  2. Combination matching (a.k.a. horizon matching)
66
Q

Symmetric cash flow matching

A

Ÿ Borrow short-term money to meet liability
Ÿ Invest in longer assets that will mature after the liability

67
Q

Combination matching (a.k.a. horizon matching)

A
  • Creates a duration-matched portfolio that is also cash flow matched in the first few years only (e.g. first 5 years)
  • Ensures short-term cash flows are met (e.g first 5 years)
  • Reduces risk of non-parallel shifts since most curvature is in short end of yield curve
  • Disadvantage: increases cost of funding liability
68
Q

List the considerations when applying dedication strategies.

A
  1. Universe considerations (credit risk, embedded options, liquidity)
  2. Optimization
  3. Monitoring (periodic performance measurement)
  4. Transaction costs (initial and rebalancing)
69
Q

Universe considerations when applying dedication strategies

A
Credit risk: using lower quality assets will increase the risk of default
 Embedded options (calls, prepayment options): complicates immunization and cash flow matching
 Liquidity: important for immunized portfolios, which require rebalancing
70
Q

Optimization considerations when applying dedication strategies

A

requires an iterative approach because there are many inputs/variations
Immunized portfolios: minimize maturity variance while matching durations and
having necessary dispersion
Cash flow matching: minimize initial portfolio cost while ensuring sufficient cash for future liabilities
Additional constraints: average quality, min/max concentrations, issuer constraints

71
Q

Monitoring considerations when applying dedication strategies

A

periodic performance measurement

  • Compare current target return with original
  • Compare current portfolio value with PV of remaining liabilities discounted at portfolio’s IRR
    • IRR = expected rate that allows portfolio to meet liabilities
  • Estimate standard deviation of terminal portfolio value: should approach zero as horizon date nears
72
Q

Describe 2 combination dedication strategies

A
  • Active/passive combination
    • Large core passive portfolio with smaller actively managed portfolio
  • Active/immunization combination (e.g. contingent immunization)
73
Q

Define the portfolio rate of return formula, accounting for leveraging

A

Leverage creates more potential for higher returns but also more downside risk

74
Q

Define a repo agreement and repo interest rate

A

sell a security (e.g. T-bill) and agree to purchase it back (usually the next day)

  • Repo interest = Repurchase Price - Sale Price
  • Repo rate = effectively the borrowing rate, which is likely different than the T-bill’s rate
  • Higher repo rate -> higher repurchase price for the seller (institution borrowing funds)
75
Q

Borrowing Cost of Repos

A

offers a low cost way to borrow short-term funds
Ÿ Term to maturity is usually overnight or a few days
Ÿ Can be extended by rolling over

76
Q

Methods of transferring Repo securities between parties

A
  • Physical delivery (highest cost and usually not practical)
  • Credit and debit accounts with banks (cheaper but still has fees)
  • Deliver to custodial account at seller’s bank (reduces costs)
  • No delivery (OK of short term transactions if parties trust each other)
    • Lowest cost but default risk
77
Q

What are the factors that increase the repo rate?

A
  1. Lower quality collateral (securities being exchanged)
  2. Longer repo term (if upward sloping yield curve - common at short end)
  3. No physical delivery (higher risk of default)
  4. Collateral is in high supply or easy to obtain (less attractive for buyer/lender)
  5. Higher prevailing interest rates in the economy
  6. Seasonal factors that restrict supply or increase demand for repos
78
Q

Describe the non-duration risk measures and their disadvantages for fixed income.

A
  • Standard deviation (or variance) – useful only if returns are normal
    • Most portfolio returns are not normal
    • The number of variances and covariances becomes very large as the number of bonds n increases: n * (n + 1)/2
    • Bond characteristics change over time
  • Semivariance – measures dispersion of returns below the target return
    • Not widely used: computationally challenging and unreliable for asymmetric returns
  • Shortfall risk
    • Does not account for the magnitude of losses
  • • Value at risk (VaR) – estimates the loss at a given percentile
    • Does not capture magnitude of losses beyond the specified percentile
79
Q

Major limitation of risk measure

A

universal and comprehensive risk measure does not exist

80
Q

List the products used in derivatives-enabled strategies

A
  • Interest rate futures and forwards (bond futures)
  • Interest rate swaps (e.g. fixed for floating)
  • Interest rate options (calls and puts on physicals or futures, caps)
  • Credit risk instruments (forwards, spread options, swaps)
81
Q

Define interest rate futures and forwards

A
  • Long party agrees to buy a bond from short party in the future at the futures price
  • Futures contract involving an underlying that pays interest (bond or other
    fixed income security)
82
Q

Delivery options with respect to Futures contracts

A

decisions that the seller can make at delivery

  • At delivery, the seller will deliver the cheapest-to-deliver (CTD) bond (a.k.a. “quality option” or “swap option”)
    • May not be the same bond as the underlying, which may not be available
  • Conversion factor – used to determine the invoice price of each acceptable deliverable Treasury
  • Timing option – seller can decide on the specific date within the delivery month
  • Wild card option – seller has until 8 PM Chicago time to give notice of intent to deliver
83
Q

Benefits of futures in managing portfolio duration

A
  • liquid
  • fast
  • cost effective
84
Q

What is the formula to approximate the number of interest rate futures contracts to a target duration?

A
85
Q

Define basis risk

A
  • Basis risk = risk of unpredictable changes in the basis
    • Basis = Bond Cash Price - Futures Price
86
Q

Define cross hedging

A

hedged bond is not the same as the bond underlying the futures contract

  • Increase basis risk
  • CTD option further complicates the process
87
Q

Define hedge ratio.

A
  • Number of futures contracts needed for the hedge (similar to approx No. of futures contract formula)
  • The above hedge ratio assumes a fixed yield spread; to generalize for non-constant yield spreads, multiply the above hedge ratio by b (“yield beta”) from a regression analysis
    • Yield on Hedged Bond = a + b (Yield on CTD bond) + Error Term
88
Q

Minimizing cross hedging

A

requires choosing a hedge that minimizes volatility between the futures (based on the CTD bond) and the hedged bond (H)

89
Q

List the 3 major sources of hedging error

A
  • Incorrect duration
  • Projected basis
  • Yield beta
90
Q

Define an interest rate swap and describe position of swap floating payer

A

Contract between two parties to exchange periodic interest payments based on a notional principal amount

  • Interest Payment = Specified Interest Rate * Notional Amount

For the floating payer, the swap is equivalent to owning portfolio with a long fixed rate bond and a short floating rate bond

91
Q

List the 3 ALM applications of swaps

A
  • Alter asset and liability cash flows
  • Adjust the portfolio duration
  • Cheaper/easier alternative to using a package of forward contracts
92
Q

Define the dollar duration (DD) of an interest rate swap.

A

For floating payer:

Swap DD = Fixed Rate Bond DD - Floating Rate Bond DD

  • =Fixed Rate Bond DD (since a floater’s duration is very small)
93
Q

Interest Rate Option Duration

A

a function of the underlying’s duration, option delta, and leverage (the 3rd term below)

94
Q

Signs of interest rate option duration

A
  • Interest rate call options have positive duration (puts have negative duration)
  • Calls have positive deltas, while puts have negative deltas
  • Delta = change in option value given a change in the underlying’s price
95
Q

List 3 ways that hedging can be done with options

A
  1. Buying protective puts – protects against rising interest rates
  2. Selling covered calls – generates premium income on out-of-the-money calls
  3. Interest rate caps, floors, and collars
    • Caps pay off if rates > cap rate; floors pay off if rates < floor rate
    • Collar = cap + floor
96
Q

Describe credit spread options

A

Payoff based on spread over a benchmark rate. Only pay off if ITM at maturity:

  • Payoff = max[(Spread at Option Maturity - K) * Notional * Risk Factor, 0]
    • Risk Factor = change in security value per 1 bps change in credit spread

This is a put option. when the spread increases over a stike spread, the bond price decreases and the credit spread option pays off.

97
Q

Describe credit forwards

A

Credit forwards have similar payoffs to credit spread options, but no downside
protection

  • Payoff = (Spread at Forward Maturity - K) * Notional * Risk Factor

where K = “contracted credit spread” similar in concept to the strike spread

98
Q

Describe credit default swaps (CDS).

A

Shifts credit risk based on a reference entity from the protection buyer to the
protection seller

  • Protection buyer pays regular swap premiums to the protection seller
  • If a defined credit event causes a loss on the reference entity bond, the protection seller pays the loss to the protection buyer
99
Q

List the advantages and uses of CDS

A
  • Reduce credit risk concentration without selling or shorting assets
  • Hedge non-publicly traded debts
  • Protection seller does not have to make an upfront investment
  • Can be tailored to specific needs since over-the-counter
100
Q

State Ways the Active Manager can Add Value

A
  1. Bond market selection
  2. Currency selection
  3. Duration management{yield curve management
  4. Sector selection
  5. Credit analysis of issuers
  6. Investing in markets outside the benchmark
101
Q

Duration with Foreign Bonds

A
  • The duration measure of a portfolio that includes domestic and foreign bonds must recognize the correlation between the movements in interest rates in the home country and each nondomestic market
  • Must adjust the duration formula because international yields are not perfectly correlated with domestic yields
102
Q

Thomas-Willner methodology for Duration of foreign bonds

A

Change in Foreign Bond Value =

Duration * Change in foreign yield given change in domestic yield * 100

103
Q

Change in yield relationship for durations of foreign bonds

A
104
Q

Define currency risk

A

Risk associated with the uncertainty about the exchange rate at which proceeds in the foreign country can be converted into the investor’s home currency.

105
Q

When does a currency loss occur in international FI markets

A

A currency loss occurs when the foreign currency depreciates against the investor’s home currency

106
Q

Currency effect composition

A
  • expected” portion - captured by the forward discount / forward premium
  • unexpected” portion - the unexpected movement of the foreign currency relative to its forward rate
107
Q

State how to compute the forward discount/premium based on the spot and forward exchange rates.

A
  • f = (F-S0) / S0
  • F is the forward exchange rate (stated as domestic currency/foreign currency)
  • S0 is the spot exchange rate (stated as domestic currency/foreign currency)
  • f is the forward discount/premium (it is a premium if positive and a discount if negative)
108
Q

State the interest rate parity (IRP) equation.

A
  • the forward foreign exchange rate discount or premium should equal the risk-free interest rate differential
  • f = id - if ( = approx)
  • Here, id is the domestic risk-free rate and if is the foreign risk-free rate
109
Q

State the three methods of currency hedging

A
  1. Forward hedging
  2. Proxy hedging
  3. Cross hedging
110
Q

Currency Forward hedging

A
  • Use forward contract between bond’s currency and home currency
  • Most popular approach
111
Q

Currency Proxy hedging

A
  • Use forward contract between home currency and highly correlated currency with bond’s currency
  • Often used when forward markets in the bond’s currency are relatively undeveloped, or because it is otherwise cheaper to hedge using a proxy
112
Q

Currency Cross Hedging

A
  • Hedge two currencies other than the home currency
  • Technique used to convert the currency risk of the bond into a different exposure that has less risk for the investor
113
Q

Formula

Currency Unhedged Return

A

approximately equals the foreign bond return in local currency (ri) plus
the currency return (e)
R = ri + e

114
Q

Currency Hedged Return

A

the sum of the foreign bond return in local currency (rl) plus the forward discount (premium) f
HR = rl + f = id + ( rl - if )

115
Q

Breakeven Spread Analysis

A
  • quantifies the amount of spread widening required to diminish a foreign yield advantage
  • The yield advantage of investing in a foreign country may disappear if either domestic yields increase or the foreign yield decline
  • Must ensure that the appropriate investment time horizon is used
116
Q

State Criteria for the Selection of a Fixed-Income Manager

A
  1. Style analysis
    • A style analysis looks at how the portfolio differs from the benchmark
  2. Selection bets
    • A manager that believes they have superior credit/security analysis skills may deviate weights based on credit or security analysis
  3. The organization’s investment process
    • Need to understand the support staff and investment processes of the manager’s organization
  4. Correlation of alphas
    • Plan sponsors will prefer low correlation among managers’ alpha to control/diversify portfolio risk
117
Q

State similarities between fixed-income and equity manager selection

A
  1. Both frequently use a consultant to identify a universe of suitable manager candidates
  2. Both realize past performance is not a reliable guide for future results
  3. Qualitative factors are important for both
  4. Management fees and expenses are important for both
    • Management fees may be even more important to monitor in the fixed-income area, because fixed-income funds tends to have a higher ratio of fees to expected outperformance