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CFA Level 3 > Reading 20: Fixed Inc PM Part 1 > Flashcards

Reading 20: Fixed Inc PM Part 1 Flashcards

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1
Q

4 activities in the investment management process:

A
  1. Setting the investment objectives (with related constraints)
  2. Developing and implementing a portfolio strategy
  3. monitoring the portfolio
  4. adjusting the portfolio
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2
Q

how to manage a portfolio against a bond market index

A
  • select a specific bond market index as the bench
  • the objective is either to match or exceed the rate of return on the index
  • aka investing on a “benchmark relative basis”
  • risk of the bond holdings are evaluated relative to both the index and in relation to the contribution to the risk of the overall (multi asset class) portfolio
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3
Q

enhancement

A

small mismatch from the index

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4
Q

totally passive to full blown active management

A
  • pure bond indexing (full replication approach)
  • enhanced indexing by matching primary risk factors
  • enhanced indexing by small risk factor mismatches
  • active management by larger risk factor mismatches
  • full blown active management
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5
Q

-pure bond indexing (full replication approach)

A

rarely attempted because of the difficulty, inefficiency and high cost of implementation… this is unique to fixed income

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6
Q

-enhanced indexing by matching primary risk factors

A

attempt to match the primary index risk factors which makes the portfolio affected by broad market moving events to the same degree as the index
this reduces costs but tracks the index less closely

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7
Q

-enhanced indexing by small risk factor mismatches

A

the mismatches are small and are intended to enhance the risk return profile enough to overcome the dif in admin costs

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8
Q

-active management by larger risk factor mismatches

A

large mismatches on the primary risk factors

the obj is to produce sufficient returns to overcome this style’s additional transaction costs while controlling risk

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9
Q

-full blown active management

A

seeks to construct a portfolio with superior return and risk

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10
Q

bums problem

A
  • coined by Siegel
  • cap weighted bond indices give more weight to issuers that borrow the most (the bums)
  • but the bums may be more likely to be downgraded and have lower returns
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11
Q

matrix pricing

A

estimating the value of a bond on the basis of inferred market value from their characteristics

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12
Q

factors explaining infrequent trading of bonds

A
  • long term inv horizon
  • limited # of distinct investors in many bond issues
  • limited size of many bond issues
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13
Q

non investability of bond indices

A
  • infrequent trading of bond issues
  • bond heterogeneity
  • limited size
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14
Q

what should very risk averse investors invest in?

A

an index with a short or intermediate duration in order to limit market value risk

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15
Q

differences between bond and equity issuances

A

there are more issuers of bonds including govts

most equity issuers only have one type of common stock but several bond issues with dif maturities, seniority and other features

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16
Q

why invest in an indexed fixed income portfolio?

A

lower fees

broad bond index portfolios provide excellent diversification-> lower risk

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17
Q

factors via to chose a bond benchmark

A

1 market value risk => as the maturity and duration increase so does market risk bc longer portfolios are more sensitive to changes in rates.

2 income risk => if stability and dependability of income are the primary needs then the long term portfolio is least risky bc it locks in the income stream and doesn’t subject it to rate fluctuations

3 credit risk

4 liability framework risk (should match duration of assets and liabilities)

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18
Q

ways to limit bums

A

having county capped and alternative weighted index versions may limit bums exposure…. though this could possibly result in greater exposure to less liquid issues

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19
Q

why might bond indicies not serve as valid benchmarks?

A

because if they are not investable, it is unrealistic and unfair to expect a manager to match its performance

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20
Q

six criteria for valid benchmarks (Bailey, Richards, Tierney)

A

unambiguous
measurable
appropriate -> may break as the index or portfolio changes over time
reflective of current investment options -> often this is broken because if they contain unfamiliar securities
specified in advance
accountable

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21
Q

custom benchmark usage

A

you may want to build a custom benchmark that is constructed according to the specific characteristics of the manager’s portfolio

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22
Q

yield curve

A

relationship between interest rates and time to maturity

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23
Q

twist of the yield curve

A

movement in contrary directions of interest rates at two maturities

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24
Q

what % and which factor accounts for most of the change in value for a bond?

A

the yield curve shift (parallel) typically accounts for about 90% of the change in bond value

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25
Q

interest rate risk

A

sensitivity of index’s returns to level of interest rates

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26
Q

yield curve risk

A

changes in the shape of the yield curve

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27
Q

spread risk

A

changes in the spread between treasuries and non treasuries

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28
Q

optionality risk

A

measures exposures to change in cash flows due to call or put features

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29
Q

portfolio duration vs key rate duration

A

interest rate risk (parallel yield curve shift) -> portfolio duration

yield curve risk (twist/non parallel move in yield curve)-> key rate duration

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30
Q

cell matching technique/stratified sampling

A
  • divides the index into “cells” that represent qualities designed to reflect the risk factors of the index
  • then select sample bonds from those in each cell to represent the cell taking into account the cells percentage of the total

ex: if A rated corporates are 4% of the index, then A rated bonds will be sampled and added until they are 4% of the portfolio.

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31
Q

4 factors to decide which index to use

A

market value risk (longer portfolios are more sensitive to interest rates)
income risk (a long portfolio locks in the income and does not subject the portfolio to fluctuating rates)
credit risk
liability framework risk

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32
Q

multifactor model technique

A

the portfolio is constructed by making use of a set of factors that drive bond returns

factors: effective duration,
key rate duration and present value distribution of cash flows, 
sector and quality percent
sector duration contribution
quality spread duration contribution
sector/coupon/maturity cell weights
issuer exposure
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33
Q

why is it bad to replicate an index with too few securities?

A

issuer event risk becomes increased

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34
Q

multi factor model technique: sector/coupon/maturity cell weights

A

some bonds like MBS have call risk that’s hard to replicate. matching its convexity from a transaction cost standpoint can be pricey.

so matching the call exposure is better done via matching the SECTOR, COUPON & MATURITY weights

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35
Q

effective duration

A

sensitivity of price to a small parallel rate shift

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36
Q

Convexity adjustment

A

for large parrell rate shifts and adj is added to improve price change accuracy bc effective duration can’t capture it all

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37
Q

key rate duration

A

measures price impact of shifts in key points on the yield curve.
we hold the spot rates constant for all points along the yield curve but one. this allows to see that point’s sensitivity.

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38
Q

present value distribution of cash flows

A

a list that associates with each time period the fraction of the portfolio’s duration that is attributable to cash flows falling in that period

the contribution of each periods cash flows to duration can be calculated bc each cash flow is effectively a 0 coupon bond pmt so the time period is the duration of the cash flow

duration of each period’s CF: time period * period’s % of total PV

the distribution of % of portfolio’s duration for each time period is what the indexer is trying to duplicate

39
Q

active risk

A

portfolio’s returns - benchmark index’s return

40
Q

tracking risk

A

-measures variability with which a portfolio’s return tracks the return of a bench
-standard dev of the active returns!
=>find the active return for each period and calc the avg active return for the periods. Subtract the avg active return from each active return and square that
=>you add that all up, divide by n-1 and take the sq root and you get the tracking risk!

41
Q

a perfectly indexed portfolio will underperform the index by ?

A

the amount of expenses and transaction costs with constructing and rebalancing the indexed portfolio

42
Q

Ways to enhance a portfolio’s returns (Volpert)

A
  1. Lower cost enhancement => anything that reduces transaction costs ex: sampling, having managers re-bid their management fees every few years
  2. Issue selection enhancements => doing credit analysis to select issues that will be upgraded and avoid downgraded ones
  3. Yield curve positioning => overweighting undervalued areas of the curve
  4. Sector and quality positioning => tilting towards short duration (5yrs and lower) corporates as they tend to have the best spread per duration risk, and under/over weighting sectors
  5. Call exposure positioning=> underweighting issues that will get called early when rates drop
43
Q

effective duration

A

duration adjusted to account for embedded options

44
Q

Interest rate relationship with callable bonds

A

As rates fall some callable bonds will be retired early.

45
Q

Extra activities required for the active manager

A
  1. Identify which index mismatches to exploit
  2. Extrapolate the market’s expectations from market data (for example use spot rates to extrapolate forward rates)
  3. Independently forecast the necessary inputs and compare these with the market expectations
  4. Estimate the relative values of securities in order to identify areas of under or overvaluation (focus on your areas of expertise)
46
Q

what is total return and what are the components of it?

A

total return is the rate of return that equates the future value of the bond’s cash flows with the full price of it

components: coupon income, change in price, reinvestment income

47
Q

total return analysis

A

assessing the expected effect of a trade on a portfolio’s total return given an interest rate forecast

48
Q

semiannual total return

A

(total future dollars/full price of the bond)^1/n -1

n= number of periods in inv horizon

49
Q

scenario analysis

A

evaluating the impact of the trade on expected total return under all reasonable sets of assumptions

50
Q

Usefulness of scenario analysis

A
  1. Ability to assess the distribution of possible outcomes =>good for conducting a risk analysis
  2. The analysis can be reversed so we begin with a range of acceptable outcomes and then calc the range of interest range mov to see how realistic it is that those i.r. moves happen
  3. The contribution to the individual components (inputs) to the total return may be evaluated
  4. Can broaden the process to evaluate the relative merits of entire trading strategies
51
Q

dedication strategies

A

Specialized fixed income strategies that are designed to accommodate specific funding needs of the investor

52
Q

immunization

A

aims to construct a portfolio that over a specified time horizon will earn a predetermined return regardless of interest rate changes

53
Q

types of dedication strategies

A

dedication strategies are either immunization or cash flow matching

54
Q

when you have a known amount of a liability and a known timing of a liability

A

ex: principal repayment

55
Q

when you have a known amount of a liability and an unknown timing of a liability

A

ex: life insurance payout

56
Q

when you have an unknown amount of a liability and a known timing of a liability

A

ex: a floating rate annuity payout

57
Q

when you have an unknown amount of a liability and an unknown timing of a liability

A

ex: post retirement health care benefits

58
Q

types of immunizations

A

single period immunization
multiple period immunization
immunization for general cash flows

59
Q

As rates increase what happens to the total return ?

A

As rates increase, the decrease in the price of a fixed inc security is usually at least partly offset by a higher amount of reinvestment income

60
Q

what is the purpose of immunization?

A

to identify the portfolio for which the change in price is exactly equal to the change in reinvestment income at the time horizon of interest => locks in an assured rate of return

61
Q

How to immunize a portfolio’s target value

A

invest in a portfolio whose 1) duration = inv horizon 2) initial PV of all CFs=PV of future liabilities

62
Q

For an upward slowing yield curve, what happens to the immunization target rate of return?

A

For an upward sloping yield curve, as the portfolio matures, time will move the duration down and there will be a lower reinvestment return….bc of the lower reinvestment return the immunization target rate of return will be less than the yield to maturity

63
Q

What kind of securities should be used in an immunization portfolio?

A

high quality, liquid instruments bc there will need to be rebalancing

64
Q

dollar duration

A

dollar duration = duration * portfolio value * 0.01

dollar duration shows the change in portfolio value for a 100 bps change in market yields (the mkt part is impt, you times the dollar duration by the mkt value of the portfolio, not the par value)

65
Q

rebalancing ratio

A

to reestablish the dollar duration to a desired level, you would calc the rebalancing ratio and multiply it by each position
[(old dollar duration/new dollar duration + 1)/100]

66
Q

nominal spread

A

the spread of a bond/portfolio above the yield of a certain maturity Treasury

67
Q

static spread

A

aka 0 vol spread

constant spread above the treasury spot curve that equates the price of the security to the market price

68
Q

OAS Option Adjusted Spread

A

spread over the benchmark yield minus the component of the spread that is attributable to any embedded optionality in the instrument

69
Q

What is the spread duration of a treasury security

A

0

70
Q

are immunized portfolios subject to risk?

A

yes, that interest rates change

71
Q

Assumptions of classical immunization theory

A

1) Changes in the yield curve are parallel across the yield curve
2) The portfolio is valued at a fixed horizon date and there are no interim cash inflows or outflows before the horizon date
3) The target value of the inv is the portfolio value at the horizon date if the interest rate structure does not change

72
Q

contingent immunization

A

Leibowitz and Weinberger

  • Provides a degree of flexibility in pursuing active strategies while ensuring a certain minimum return in the case of a parallel rate shift
  • Immunization is a fall back strategy if the actively managed portfolio does not grow at a certain rate
73
Q

cushion spread

A
  • difference between the minimum acceptable return and the higher possible immunized rate
  • concept in contingent immunization
  • ex: must earn 3% and can immunize at 4.75% => can actively manage the portfolio. If the return drops to the 3% safety level, then active mgmt dropped and portfolio is immunized.
74
Q

economic surplus

A

MV assets - MV liabilities

in order to achieve economic surplus, the duration and convexity of both the assets and liabilities must be understood

75
Q

What is the largest risk a portfolio manager faces?

A

Interest rate risk

76
Q

contingent claims risk

A

A contingent claim bond is dependent on some kind of outcome and hence there is risk. For example, if rates fall, and you hold a MBS then as mortgages prepay principal, you may get your principal back sooner than expected and have to reinvest it at lower rates.

77
Q

cap risk

A

assets that have floating payments typically have caps and if rates rise too much, asset returns are capped

78
Q

bullet portfolio

A

a portfolio that has the majority of the maturities very close to the inv horizon => little reinvestment risk bc u’d barely be reinvesting since the maturities of the bonds is so close to the horizon date

79
Q

barbell portfolio

A

has both short and long maturities relative to the horizon date. It is riskier than a bullet portfolio bc by having a pmt far away from the horizon date there is more reinvestment risk

80
Q

Does a pure discount bond maturing at the horizon date have any reinvestment risk?

A

No because 0 coupon bonds have no cash flows and since there are no cash flows to reinvest, there is no reinvestment risk

81
Q

Maturity variance

A
  • concept by Fong and Vasicek
  • M^2
  • variance of time to payment around the horizon date =>the weight for a time is the proportion of the bond’s total PV that the pmt received at that time represents
  • measures how much an immunized portfolio differs from the ideal immunized portfolio that only has a 0 coupon bond with same maturity as the time horizon
82
Q

how can we find the optimal immunized portfolio?

A

via linear programming

83
Q

confidence interval and immunized portfolios

A

confidence interval = target return +_ K * sd of target return

k=# of standard deviations around the expected target return . The higher the confidence level, the larger k and the wider the band around the expected target return

84
Q

Multiple Liability Immunization

A
  • it’s not enough to match the duration of the portfolio to the duration of the liabilities
  • each liability must be separately immunized (no need to have actual securities individually match the liabilities but the pmt stream must be decomposed such that each liability is separately immunized)
85
Q

Fong and Vasicek’s conditions to ensure multiple liability immunization with parallel rate shifts

A
  1. PV assets=PV liabilities
  2. Composite duration of portfolio = Composite duration of liabilities
  3. Distribution of durations of individual portfolio assets must have a wider range than the distribution of the liabilities…..it should be shorter to have funds to pay the liabilities and must have an asset that is = > the longest liability in order to avoid the reinvestment risk that could jeopardize pmt of the longest duration
86
Q

Fong and Vasicek and risk/return trade off

A
  • Duration of the portfolio is at all times equal to the horizon length
  • The immunization risk measure can be relaxed if the compensation in terms of expected return warrants it
  • The strategy maximizes a “lower bound” (aka:lower confidence interval limit”) on the portfolio return
87
Q

cash flow matching

A

A bond is selected with a maturity that matches the last liability and an amount of principal=last liability-final coupon. The coupons help reduce the remaining liabilities. Another bond is selected for the next to last liability adjusted for any coupons of the first bond and this continues

88
Q

what is better CF matching or immunization

A

immunization is better despite CF matching being easier to understand

89
Q

Why is immunization better than CF matching

A

If perfect matching is unlikely then immunization is better because:

1) CF matching requires a relatively conservative rate of return assumption for short term cash and cash balances may be large. But immunized portfolios are fully invested
2) Funds from a CF matched portfolio must be available when each liability is due which is harder but for immunized portfolios funding is achieved by a rebalance

90
Q

symmetric cash flow matching

A

allows for the short term borrowing of funds to satisfy a liability prior to the liability due date
this results in a reduction in the cost of funding a liability

91
Q

combination matching

A
  • strategy that combines multiple liability immunization and cash flow matching
  • creates a portfolio that is duration matched and cash flow matched in the first few years
  • this ensures liquidity needs are provided in those first few years which is when you may have more interest rate risk
  • cost to fund liabilities is more expensive
92
Q

immunization and low quality securities

A

immunization assumes that securities are responsive only to overall changes in interest rates. This may not be the case for low quality securities.

93
Q

Securities with imbedded options and immunization

A

immunization is concerned with duration matching but securities with embedded options such as call options or prepayment options can complicate duration and hence not be immunized

CFA Level 3 (4 decks)

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