YIELD CURVE STRATEGIES

Question 1

How to we calculate the butterfly spread (also know as the curvature of the curve)

Answer 1

• short term spread + (2 x medium spread) - long spread

Question 2

Identify the five step return decomposition process to identify the drivers of changes in bond prices

Answer 2

1. Coupon income = annual coupon amount / current bond price
2. Rolldown return = (projected bond price (BP) assuming no yield curve change– beginning BP) / beginning BP
3. Price change due to investor yield change predictions: (–MD × ΔY) + (½C × ΔY2)
4. Price change due to investor spread change predictions: (–MD × ΔS) + (½C × ΔS2)
5. Currency G/L: projected change in value of foreign currencies weighted for exposure to the currency

Question 3

Identify 3 cash-based static yield curve strategies (considering we are in an upward sloping yield curve scenario)

Answer 3

1. Buy and hold - extend the duration of portfolio, profit from higher coupon returns from longer dated bond.
2. Rolling down the yield curve - profit from higher coupon income and from rolling returns.
3. Repo carry trade - form of leverage, borrow funds at lower rate to invest in longer dated bonds with higher returns.

Question 4

Identify 2 derivatives-based static yield curve strategies

Answer 4

1. Long futures contracts - leverage contract.
2. Enter receive-fixed swap - receive fixed rate vs paying floating MRR.

Question 5

Explain what it means when we say that curvature is increasing

Answer 5

It means that medium rates are increasing relative to short and long term rates. We call it a negative butterfly twist.

Question 6

Whats the formula to calculate effective duration and effective convexity of an embedded option.

Answer 6

Effective duration :

(-PV) - (PV+) / 2 * PV t0 * change in yield

Effective convexity : (-PV) + (PV+) - 2*PV / change in yield * PVt0

Question 7

Explain the strategy to hedge an investment in a coupon paying foreign bond.

Answer 7

The manager can hedge this investment by entering a fixed-fixed cross curency swap. The manager will receive the amount to pay his coupon paying bonds in the bonds currency and will pay the counterparty the amount in domestic currency. During the life of the swap, the manager will receive domestic currency payment and will pay foreing currency.

At the end, pay back borrowed fund (foreing currnecy) and receive back the initial payment (domestic currency).