SAA: Risk management with FI securities

Question 1

Interest rate risk

Answer 1

•Interest rate sensitivity – stylized facts
1.Bond prices and yields are inversely related

2. An increase in a bond’s yield to maturity results in a smaller price change than a decrease of equal magnitude
3. Long-term bonds tend to be more price sensitive than short-term bonds
4. As maturity increases, price sensitivity increases at a decreasing rate
5. Interest rate risk is inversely related to the bond’s coupon rate
6. Price sensitivity is inversely related to the yield to

Question 2

What Determines Duration

Answer 2

–Rule 1: The duration of a zero-coupon bond equals its time to maturity

–Rule 2: Holding maturity constant, a bond’s duration is higher when the coupon rate is lower

–Rule 3: Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity

–Rule 4: Holding other factors constant, the duration of a coupon bond is higher when the bond’s yield to maturity is lower

–Rules 5: The duration of a level (non-growing) perpetuity is equal

Question 3

Why Do Investors Like Convexity?

Answer 3

• Bonds with greater curvature gain more in price when yields fall than they lose when yields rise
• The more volatile interest rates, the more attractive this asymmetry is
• Bonds with greater convexity tend to have higher prices and/or lower yields, all else

Question 4

Passive management of interest rate

risk

Answer 4

Bond Index Funds

Immunization

Question 5

Active management of interest rate

risk

Answer 5

•There are two sources of value in active bond management:
–Interest rate forecasting – anticipate movements across the fixed-income market
–Identification of relative mispricing within the fixed-income market.
–Swapping strategies:
•Substitution swap, Intermarket spread swap, Rate anticipation swap, Pure yield pickup swap, Tax swap
•Horizon Analysis
–Select a particular holding period and predict the yield

Question 6

Risk management

Answer 6

•There are various financial instruments to manage risks
–Interest rate risk can be hedged by futures and swaps, i.e. interest rate or inflation swaps, interest rate forward or futures
–Credit risk is hedged by credit default swap or by securitization (e.g. CDO)
–Currency risk is most often tackled by FX futures

Question 7

Futures and forwards

Answer 7

Forward contract
–A deferred-delivery sale of an asset with the sales price agreed on now.

•Futures contract
–Similar to forward but features formalized and standardized contracts.

•Key difference in futures
–Standardized contracts create liquidity
–Marked to market
–Exchange mitigates counterparty (credit) risk

Question 8

Swaps

Answer 8

•Swaps are multi-period extensions of forward contracts.
•Credit risk on swaps
–Bilateral transactions (no central clearing) carry counterparty risk
•Types:
–Interest rate swap calls for exchanging cash flows based on a fixed rate for cash flows based on a floating rate.
–Foreign exchange swap calls for an exchange