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CFA Level 3 - Fixed Income > SS9 - Management of Passive and Active Fixed Income Portfolios > Flashcards

SS9 - Management of Passive and Active Fixed Income Portfolios Flashcards

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1
Q

What are the two approaches to Bond portfolio management with respect to an index?

A

Active: manager thinks they can outperform index.

Passive: manager agrees with market forecasts and values

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2
Q

What are the 5 classifications of bond portfolio management?

A
  1. pure bond indexing (no deviations from index)
  2. enhanced indexing by matching primary risk factors (some deviation, but match overall duration)
  3. enhanced indexing by small risk factor mismatches (some deviation, but match overall duration)
  4. active management by larger factor mismatches (deviate from average duration, as well as other deviations)
  5. full-blown active management (deviate from average duration, as well as other deviations)
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3
Q

What are the main attributes of pure bond indexing?

A

Attributes:

  • manager replicates every dimension of the index
  • every bond in the index is purchased and its weight is determined by its weight in the index

Cons:

  • difficult and costly to implement (bonds oyu need to purchase may be illiquid or unavailable)
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4
Q

What are the main attributes of enhanced indexing by matching primary risk factors?

A

Attributes:

  • manager uses a sampling approach to hold only a percentage of bonds in index

Pros:

  • reduces costs in constructing portfolio
  • matching risk factors means portfolio has same exposures as index
  • given the lower transaction costs, it should outperform pure bond indexing
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5
Q

What are the main attributes of enhanced indexing by small risk factor mismatches?

A

Attributes:

  • designed to earn about the same level of return as index
  • exposure to larger risk factors is maintained
  • smaller mismatches are done by pursuing relative-value strategies.
  • the small tilts are designed only to compensate for transaction costs
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6
Q

What are the main attributes of active management by larger risk factor mismatches?

A

Attribute:

  • the degree of mismatches is higher
  • manager pursues more significant qualit and value strategies
  • duration of portfolio can be altered somewhat
  • try to earn enough return to cover admin costs
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7
Q

What are the main attributes of full-blow active management?

A

Attributes:

  • no-holds barred
  • actively pursue strategies:
    • tilting
    • relative value
    • duration
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8
Q

What are the advantages and disadvantages of pure bond indexing?

A

Advantages:

  • returns before expenses very closely track index
  • exact same risk exposures as index
  • low fees for investor

Disadvantages:

  • costly to implement
  • difficult to implement
  • lower expected return than index due to transaction costs
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9
Q

What are the advantages and disadvantages of enhanced indexing by matching primary risk factors?

A

Advantages:

  • less costly to implement
  • increased expected return (lower t-costs)
  • maintains exposure to the index’s primary/major risk factors

Disadvantages:

  • management fees are higher
  • a little more tracking error
  • lower expected return than index
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10
Q

What are the advantages and disadvantages of enhanced indexng by small risk factor mismatches?

A

Advantages:

  • same duration as index
  • increased expected return
  • reduced manager restrictions

Disadvantages:

  • increased risk
  • increased tracking error
  • increased management fees
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11
Q

What are the advantages and disadvantages of active management by larger risk factor mismatches?

A

Advantages:

  • increased exected return
  • reduced manager restrictions
  • ability to tune portfolio duration

Disadvantages:

  • increased risk
  • increased tracking error
  • increased management fees
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12
Q

What are the advantages and disadvantages of full-blown active management?

A

Advantages:

  • increased expected return
  • few (if any) manager restrictions
  • no limits on duration

Disadvantages:

  • increased risk
  • increased tracking error
  • increased management fees
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13
Q

What are the four primary considerations when selecting a bond benchmark?

A
  1. market value risk
  • MV of long-duration portfolios more sensitive to changes in yield than shorter duration portfolios
  • greater risk aversion –> shorter duration portfolio
  1. income risk
  • if client is dependent on cash flows, those should be consistent
  • longer duration fixed-rate portfolios have lower income risk
  1. credit risk
    * credit/default risk of benchmark should closely match that of the portfolio
  2. liability framework risk
  • if managing a portfolio to met liabilities, this risk should be minimized
  • if longer term liabilities, use longer-term bonds and vice versa
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14
Q

How do the four risks vary with other factors?

A

Market Value Risk

  • more duration = more market value risk
  • more risk aversion –> get shorter duration portfolio

Income risk

  • longer maturity = less income risk
  • more dependent on income stream –> get longer duration portfolio

Credit risk

  • benchmark should match portfolio

Liability framework risk

  • should always be minimized
  • only relevant to portfolios that are designed to meet liabilities
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15
Q

What are the risk dimensions of a fixed income portfolio or benchmark?

A
  1. duration
  2. key rate duration
  3. duration contributions
  4. spread durations
  5. sector weights
  6. distribution of cash flows
  7. diversification
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16
Q

Explain the process of stratified sampling.

A
  1. separate bonds in index into risk factor cells (sector, quality, duration, callability, etc.)
  2. measure total value of bonds in each cell
  3. determine each cell’s weight in index
  4. select a sample of bonds from each cell and purchased enough to match that cell’s weight
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17
Q

What procedure will allow a manager to construct a portfolio with the exact same risk exposures as a benchmark but with different securities?

A

Use a multifactor model.

This requires risk profiling, which means measuring the index’s exposure to factors like duration, key rate duration, cash flow distribution, sector, quality, etc.

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18
Q

What is duration?

A

Duration is an estimate of the change in the value of a portfolio given a small, parallel shift in the yield curve.

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19
Q

What is key rate duration?

A

Key rate duration measures a portfolios sensitivity to twists in the yield curve.

Important because you could have a portfolio whose total duration matches the index but that has very different key rate duration. This means it will respond differently to non-parallel shifts in the yield curve.

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20
Q

What is the present value distribution of cash flows?

A

The proportion of the index’s total duration attributable to cash flows falling within selected time periods.

It measures how the total duration of the index is distributed across its total maturity.

Example:

For a portfolio with duration of 10 years, measure the proportion of cash flows that come in over every 6 month period.

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21
Q

What is the duration of a zero-coupon bond?

A

The duration of a zero-coupon bond is the same as the amount of time until it pays.

Example: the duration of a 6-month zero coupon bond is 0.5.

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22
Q

What are the risks and measures for all bond risk exposures?

A

Interest Rate Risk

  • exposure to yield curve shifts
  • measured with duration

Yield Curve Risk

  • exposure to yield curve twists
  • measured with PVD or Key rate durations

Spread Risk

  • exposure to spread changes
  • measured with spread duration

Credit Risk

  • exposure to credit changes
  • measured with duration contribution by credit rating

Optionality Risk

  • exposure to call or put risk
  • measured with delta
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23
Q

What are the differences between total return analysis and scenario analysis?

A

Scenario analysis assesses total return undr a varying set of assumptions (different scenarios)

Example scenarios: interest rate movements, spread movements, reinvestment rates, etc.

If you do only expected total return analysis, you only have one point estimate. If you go a bit further and do scenari analysis, you can assess not only the return but its volatility as well.

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24
Q

What are the three sources of return on a bond?

A
  1. return due to price changes
  2. return due to coupons received
  3. return due to interest on coupons
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25
Q

What is immunization?

A

Immunization is a strategy to minimize interest rate risk.

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26
Q

What are the components of interest rate risk?

A
  1. price risk

Change in value of bond due to interest rate changes

  1. reinvestment risk

increase/decrease in reinvestment income as interest rates increase/decrease

Price risk and Reinvestment risk are opposite effects.

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27
Q

What is classical single-period immunization?

A

Classical single-period immunization is a strategy to balance change in value of a portfolio with the return form the reinvestment of coupon and principal repayments.

Goals:

  • if interest rates increase, portfolio loses value but reinvestment income at the higher rates should compensate
  • if interest rates decrease, reinvestment income decreases but the increase in the portfolio value should compensate
28
Q

At a high level, how do you immunize a portfolio?

A

Construct a portfolio with an effective duration equal to the liability horizon.

Note: This will only be effective for a single, parallel shift in the yield curve.

29
Q

In detail, how do you immunize a single obligation?

A
  1. Select a bond with an effective duration equal to the duration of the liability
  2. Purchase an amount of that bond equal to the present value of the liability.
30
Q

What happens if the duration of the portfolio is less than the duration of the liability?

A

The portfolio is exposed to reinvestment risk.

Since more cash flows will be received before the liability is due, you’ll have to reinvest at the prevailing interest rates.

Losses from the reinvested coupon and principal payments would be larger than any gains in the market value appreciation of the bonds.

Won’t have enough money to pay the liability.

31
Q

What happens if the duration of the portfolio is more than the duration of the liability?

A

The portfolio will be exposed to price risk.

If interest rates are increasing, the losses on the decreased value of the bonds will be greater than any gains gotten from coupon and principal reinvestment.

Won’t have enough money to meet liability.

32
Q

What things cause a single liability portfolio to not be immunized any more?

A
  1. passage of time
  2. interest rates change more than once

This means that the portfolio must be rebalanced. This will lead to higher transaction costs.

33
Q

What characteristics of individual bonds must be considered when you are considering constructing an immunized portfolio?

A
  1. Credit rating

It is assumed that none of the bonds will default.

  1. Embedded options

It can be difficult to estimate duration on bonds that have options as the cash flows are difficult to forecast

  1. Liquidity

If a portfolio needs to be rebalanced, bonds will need to be bought or sold. Thus, liquidity is a concern.

34
Q

How can you immunize a portfolio against non-parallel shifts?

A
  • Construct a portfolio of all zero-coupon bonds that mature at the investment horizon (zero reinvestment risk)
  • Concentrate cash flows around the horizon
  • Keep the dispersion of cash flows around the horizon to a minimum. More dispersed cash flows have higher reinvestment risk.
35
Q

How do you calculate effective duration of a *portfolio * of bonds?

A

The effective duration of a portfolio of bonds is the weighted average of the individual bond durations.

36
Q

How do you calculate the duration contribution of a single bond to overall portfolio duration?

A

Duration contribution is the weight of the bond or sector multiplied by the effective duration of that bond or sector.

Duration contribution is the “amount” of duration that the bond or sector contributes to the portfolio.

37
Q

How do you calculate the dollar duration of a single bond?

A

DD = -(duration) * (0.01) * (price)

38
Q

How do you calculate the dollar duration of a portfolio of bonds?

A

The dollar duration of a portfolio is the sum of the individual dollar durations.

DDp = DD1 + DD2 + … + DDn

39
Q

What re the steps necessary to rebalance a portfolio to achieve a particular target dollar duration?

A
  1. Calculate the current dollar duration of the portfolio
  2. Calculate the rebalancing ratio and use it to determine the required percentage change in the value of the portfolio.

Rebalancing Ratio = old DD / new DD

RR - 1 = the percentage change in each bond to get the portfolio back to the target dollar duration.

40
Q

What is a lower cost option to changing the dollar duration of a portfolio other than increasing/decreasing the value of each bond in the portfolio?

A

The manager can select a controlling position and then only alter the holdings in that position.

For example, if we need to increase portfolio duration, we may pick the bond with the longest duration as the controlling position as we’ll need less of it it get back to our target duration.

Steps:

  1. figure out how much more dollar duration we need.
  2. add the current dollar duration of the controlling position and the amount of additional dollar duration we need
  3. new total dollar durationcp / old dollar durationcp * MVcp of Bond cp will give us the total MV of cp that we need to get to our target.
  4. Purchase (#3 - MVcp) of bond cp
41
Q

What does spread duration measure?

A

Spread duration measures the sensitivity of a non-Treasury issue to a change in its spread above Treasuries of the same maturity.

(more spread, more perceived risk)

42
Q

If a manager forecasted a widening spread between a certain sector of bonds and Tresuries, what would he do?

A

The manager would want to reduce his weight in that sector because as the spreads widen, those bond’s prices will fall.

Similarly, if a spread were forecasted to narrow, he’d want to increase the weight of those bonds as when the spreads narrow, the bond’s prices will increase.

43
Q

What are the three spread duration measures for fixed-rate bonds?

A
  1. Nominal spread

Spread between the nominal yield on a non-Treasury and a Treasury of the same maturity

  1. Zero-volatility spread (ZVS, static spread)

Spread that must be added to the Treasury spot rate curve to force equality between the PV of a bond’s cash flows (discount at treasury spot rate + spread) and the market price of the bond

Measures percentage change in one-time 100bps change in ZVS.

  1. Option-adjusted spread (OAS)

Approximate percentage change in price for a 100 bps change in OAS.

44
Q

What are the four extensions that have been made to classical immunization?

A
  1. multi-functional duration
  2. multiple-liability immunization
  3. relaxation of minimum risk requirement
  4. contingent immunization
45
Q

What is multifunctional duration (first extension to classical immunization)?

A

Multifuctional duration is the use of key rate durations. Manager focuses on certain key rate maturities.

Example: A portfolio contains a lot of MBS (subject to prepayment risk). Unlike most bond portfolios that would increase in value as interest rates fall, MBS will prepay when interest rates fall. Thus, they do not increase as much as bonds that are not callable.

Thus, focusing on certain key rates is important.

46
Q

What is multi-liability immunization (second extension to classical immunization)?

A

Multi-liablity immunization is used to ensure that a portfolio can meet multiple liabilities.

Rather than focus on a single liability, there can be numerious certain (or even uncertain) liabiities with accompanying horizon dates.

47
Q

What is increased risk (third extension to classical immunization)?

A

As long as the manager does not jeopardize meeting the liability structure, he can pursue strategies that have more risk but may lead to excess portfolio value.

48
Q

What is contingent immunization (fourth extension to classical immunization)?

A

Contingent immunization mixes active and passive management techniques.

Like immunization:

there must be a liability or set of liabilities

Unlike immunization:

beginning value of portfolio must exceed PV of liabilities. This difference is called the surplus or economic surplus

The surplus can only exist if the invest will accept a floor return that is less than the currently available immunization rate.

49
Q

What is the cushion spread?

A

cushion spread = available immunixation rate - investors minimum floor return

50
Q

What are the steps involved in a contingent immunization scheme?

A
  1. Determine the PV of liability
  2. Compare to PV of assets to determine value of the surplus
  3. As time passes, value of suplus will change. As long as the surplus is positive, portfolio can be actively managed.
  4. As soon as surplus becomes zero, must passively manage.
51
Q

What are some key points about contingent immunization strategy to remember for the exam?

A
  1. assume semiannual compounding unless told otherwise
  2. if duration and convexity of the asset doesnt match the d/c of the liability, the surplus will change as (a) market conditions change and (b) time passes
  3. The larger the initial surplus, the larger adverse market move can be tolerated
  4. before surplus becomes neative, portfolio must be immunized. once it becomes negative, it will no longer be possible to reach the target balue beacause the current value of assets is not large enough to grow to the target at te prevailing immunization rates
52
Q

What are the three risks associated with managing a portfolio against a liability structure?

A
  1. Interest rate risk
  2. contingent claim risk (call or prepayment risk)
  3. cap risk
53
Q

What is interest rate risk?

A

Interest rate risk is the primary concern when managing a fixed income portfolio.

To avoid interest rate risk, the manager should match the portfolio’s duration and convexity with that of the liability.

Convexity can be difficult to measure, especially those with negative convexity.

54
Q

What is contingent claim risk?

A

Callable bonds are generally called only after rates have fallen. Result is manager loses coupons at the higher rate and then has to reinvest principal at the lower prevailing rates.

To manage contingent claim risk, the manager must condider the convexity of bonds.

55
Q

What is cap risk?

A

Cap risk applies to floating rate bonds. If the coupon on the floating rate bond doesn’t fully adjust upward in an environment of rising rates, the market value of the bond will adjust downward.

The assest and liabilities will not adjust in sync and the surplus will be cut into.

56
Q

In order to minimize reinvestment risk, would you select a barbell or bullet strategy?

A

A bullet strategy would have less reinvestment risk than a barbell strategy.

57
Q

What is the M-Square measure, and what should the manager do with it?

A

M-Square = M2 = maturity variance

It is the variance of the differences in the maturities of the bonds used in the immunization strategy and the maturity date of the liability.

If all the bonds have the same maturity date as the liability, M2 is 0.

58
Q

What conditions are necessary to achieve multiple liability immunization in the face of a parallel rate shift?

A
  1. Assets and liabilities have the same present values.
  2. Asset and liabilities have the same aggregate durations.

Note: this only requires teh weighted average durations of the liabilities and assets be equal.

  1. The range of the distribution of durations of the assets in the portfolio exceeds the distribution of liabilities.
59
Q

What conditions are necessary to achieve multiple liability immunization in the face of a non-parallel rate shift?

A

Linear programming models can be used to construct minimization-risk immunized portfolios for multiple liabilities.

The minimization procedure is subject to the constraints imposed by the conditions required for immunization under the assumption of a parallel shift along with any other investment constraints.

60
Q

How can general future cash flow be incorporated into an immunization strategy?

A

You can look at the expected cash flow as a zero-coupon bond with maturity/duration being the time when the cash flow is expected.

61
Q

What is the relationship between risk minimization and return maximization?

A

Risk minimization is a standard condition for classical immunization.

Return maximization behind *contingent immunization. * If the manager feels that he can generate even greater returns, he should pursue active management in hopes of generating excess value.

62
Q

What is cash flow matching?

A

Cash flow matching is using cash flows to construct a portfolio that will fund a stream of liabilities with portfolio coupons and maturity values.

Other attributes:

  • cash flow matching causes durations to be matched
  • cash flow matching is more stringent in that the timing and amounts of the asset cachs flows must also correspond to the liabiltiies. Thus, as time pases, the durations stay matched and rebalancing should not be needed.
63
Q

What are the steps to construct a portfolio using cash flow matching?

A
  1. Select a bond with maturity equal to that of the last liability payment date.
  2. Buy enough in par value of this bond such that the principal and final coupon fully fund the last liability.
  3. Using a recursive procedure, choose another bond so that its maturity value and last coupon, plus the coupon on the longer bond, fully fund the second-to-last liability payment.
  4. Continue this procedure until all liability payments have been addressed.
64
Q

What are the main differeces between cash flow matching and multiple-liability immunization?

A
  1. Since cash flow matching depends on all cash flows of the portfolio, expectations regarding short-term reinvestmet rates and borrowing rates are critical. Thus, managers must use conservative assumptions and deviations from a true cash flow match should be modest and associated with a significant expected cost saving. This tends to increase overall cost to purchase the cash flow matched portfolios. Immunization by duration matching is less restrictive and may cost less.
  2. In a cash-flow matched portfoli, only cash flows received prior to the liability may be used for the obligation. An immunized portfolio is less restrictive in that it is only required to have sufficient value at the liability date.
65
Q

What is combination/horizon matching?

A

Combination matching is a combination of multiple liability immunization and cash flow matcing that can be used to address the asset/liability matching problem.

During the first few years: liabilites are cash flow matched.

Later years: liabilities are duration matched.

66
Q

What are the advantages of combination matching over multiple-liability matching?

A
  • provides liquidity in the initial period
  • reduces risk associated with non-parellel shifts in the yield curve
    • initial cash needs are met with the asset cash flows
    • no rebalancing needed
67
Q

What are the disadvantages of combination matching compared to multiple-liability immunization?

A

Combination matching is generate more expensive.

CFA Level 3 - Fixed Income (2 decks)

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