Yield Curve Strategies Flashcards
What are the purposes of active yield curve strategies ?
They are designed to capitalized on the expectations regarding the level, slope or shape of the yield curves.
How to compute the curvature ?
We can use the butterfly spread = - (Short term yield) + (2*Medium term yield) - (long term yield)
Elaborate on the dynamic of the yield curve movement.
The 3 changes in yield curve do not occur in isolation. They are correlated with one another. For an upward shift in level, the yield curve tend to flatten and lose curvature, for a downward shift, the yield curve tends to steepens and gain curvature, this is due to the higher volatility of short term rate compared to long term.
What are the parameters of the bonds ?
Macaulay Duration, Modified Duration, Effective Duration, Key rate Duration, Money Duration,
Macaulay Duration increases linearly with the maturity.
Convexity.
Convexity is further desired when interest rate vola is expected to increase.
Coupon-bearing bond have more convexity than zero-coupon bonds of same duration.
How to enhance portfolio yield in low interest rate environment.
Extend maturity if the yield curve is upward sloping or buy lower-credit security
What are the active strategies under the assumption of stable yield curve?
Buy and hold Roll down the yield curve Sell convexity -Write call option -Purchase callable bonds -Purchase MBS Carry trade
What are the active strategies under the assumption of yield curve movement ?
Buy convexity
Duration management
Elaborate on Carry trade
Intra market carry trade
- Buy a bond and finance it in the repo market
- Receive fixed and pay floating on interest rate swap
- Take long position in future
Inter market carry trade
- Borrow in a lower rate currency , invest in the higher
currency rate bond
-Enter a currency swap whereby you make payment
in the lower currency rate and receive payment in
the higher rate currency
-Borrow in a higher currency rate, invest in an
instrument denominated in that currency and
convert the financing in a lower rate currency via a
FX forward
Elaborate on Duration management
It consists in shortening durations in anticipation of rising interest rates and lengthening portfolio duration in anticipation of declining interest rates.
% change in portfolio = -Modified duration * Δ yield
One could use derivative to manage Duration:
-Future
-Leverage
-Interest rate swap
(Effective PVBP received fixed - Effective PVBP
paying floating = Net effective PVBP
Elaborate on bullet and barbell structures
Bullet portfolio are used to take advantage of steepening yield curve
Barbell are used to take advantage of flattening yield curve
Barbell outperform Bullet when the yield curve flattens and underperform when the yield curve steepens
Elaborate on Key rate duration and Effective duration
The sum of key rate duration must be equal to the effective duration.
How to compute total return ?
Total return = [(-1 * Ending effective duration) * (ending yield to maturity -beginning yield to maturity)] + ( beginning yield to maturity)
How to proceed in anticipation of increased volatility in interest rate?
Given a portfolio of several bonds, sell the one with the lowest convexity and purchase additional bonds for those with the higher convexity while maintaining the portfolio duration. This will increase the convexity but may reduce the yield.
Elaborate on butterfly structure
A butterfly structure is composed of a barbell and a bullet. A butterfly with long wing and short body has positive convexity and is profitable in volatile environments. The reverse is good for stable environments.
Butterfly can be elaborated based on
- Duration neutral strategy
- 50/50 weighting
- Regression weighting
How to add convexity for short maturity ?
It is hard to add convexity for short maturities, the best way is to buy some call options. However understand that there is a drag on performance when we add convexity and the rate do not move significantly.
