FIN 403 Exam 3

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Duration generally ___________ with its time to maturity

increases

Sensitivity of bond prices to changes in yields ______ at a ________ rate as maturity increases

increases, decreasing

Sensitivity of a bond's price to a change in YTM is _____ related to the YTM at which it is currently selling

inversely

Bond Prices and Yields Relationship

inversely related

Fixed Income Portfolio Strategies

generally result in a lower return and lower volatility relative to equity

Duration is shorter when the coupon is _______

greater

Matched Funding Strategies

hold bonds with CF that align with investor needs assumes liabilities are predictable (1) pure cash match (2) immunization (3) horizon matching

Active Strategy: Yield Spread Analysis

if a yield difference is not normal, execute a swap assume normal relationships exist between bonds in an alternative sector

Protective Put

if stock price dec, you can sell at X (1) own underlying asset (long stock) (2) buy a put on the asset (long put)

Passive Bond Strategies

(1) Buy and Hold--select a portfolio of a bonds based on investor objectives and constraints (2) Indexing -- construct a portfolio that mimics a bond index and limit tracking error

Bond Pricing Implications

(1) bond prices and yields are inversely related (2) an increase in a bond's YTM results in a smaller price change than a decrease of equal magnitude (3) longer term bonds are more price sensitive to changes in interest rates (4) the sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases (5) interest rate risk is inversely related to a bond's coupon rate (6) the sensitivity of a bond's price to a change in YTM is inversely related to the YTM at which it is currently selling

Straddle

(1) buy put (2) buy call same X, T, and asset buyer wants low volatility

Duration Properties

(1) duration of a zero coupon bond is its time to maturity (2) a bond's duration is shorter when the coupon is greater (3) a bond's duration generally increases with its time to maturity (4) the duration of a coupon bond is greater when YTM is lower (5) duration provides a better estimate for small yield changes

Why yields on STRIPS differ from theoretical spot rate constructed with on the run coupons

(1) liquidity differences - STRIPS are less liquid (2) tax issues

Covered Call

(1) own underlying asset (long stock) (2) sell a call on the asset (short call) buy with hope price remains stable so you keep stock and earn income from the premium

Bond Portfolio Strategies

(1) passive (2) active management (3) core plus (4) matched funding (5) contingent procedure

Interest Rate Risk and Coupon Rate Relationship

Inversely related

Matched Funding Strategy: Pure Cash Match

CF match needs or dedicated with reinvestment (CF don't exactly match buy you can reinvest to make up difference)

Contingent Procedure

a form of structure management client sets a floor rate for the portfolio below the market rate cushion spread = market - floor when hit a trigger point, manager immunizes to ensure floor rate

Active Strategy: Valuation Analysis

attempt to find a mispriced bond estimate intrinsic value relative to market price

Active Strategy: Interest Rate anticipation

attempt to get capital gains if yields decrease, but preserve capital if yields increase if anticipate an increase in rates, decrease your duration risky strategy

Active Bond Strategies

attempt to outperform a benchmark on a risk adjusted basis (1) interest rate anticipation (2) valuation analysis (3) credit analysis (4) yield spread analysis

Put Call Parity

c - p = S - PV(x) if does not hold, arbitrage is possible

American Option

can be exercise up to maturity

European Option

can only be exercised at maturity

Matched Funding Strategy: Horizon Matching

cash match during early years and duration match in later years better if you have non parallel shift of yield curve

Bootstrapping

constructing a theoretical spot rate curve

On the Run Yield Curve

curve for recently issued coupon bonds selling near par

Pure Yield Curve

curve for zero coupon or stripped treasuries

Active Strategy: Credit Analysis

determine expected changes in default risk buy if expect upgrade look at profitability, stability of profits, interest coverage, liquidity, market cap, assets

Duration of a zero coupon bond

its time to maturity

Duration of a coupon bond is greater when YTM is _____

lower

Core Plus Management

manage a significant portion of a portfolio passively (75%) and actively manage the remainder in plus sectors (25%) (1) get higher returns from market inefficiencies outside the core sectors (2) increase opportunities for using selection skills (3) alter composition of fixed asset classes

Longer term bonds are ____ price sensitive to changes in interest rates

more

Futures/Forwards

obligation to buy or sell an asset at price F some specified time in the future worst case get a negative payoff no premium to pay

Substitution Swap

relies on interest rate expectations assumes short term imbalance in yield spreads compare a current and a mispriced bonds' RCY and return assumes a correction

Call (put)

right to buy (sell) underlying asset at a specific price for a specific time period

STRIPS

separate trading of registered interest and principal of securities split coupon bond into several zero coupon bonds with came CF and different maturities

Duration provides a better estimate for _______ yield changes

small

(Increase in a bond's YTM results in a _______ price change than a decrease of equal magnitude

smaller

Forward Rate

the rate that makes you indifferent between longer and shorter term investments

Matched Funding Strategy: Immunization

to immunize from interest rate risk, set portfolio duration equal to investment horizon issues: duration continually changes and yield do not stay constant need to constantly rebalance portfolio to stay immunized duration < horizon = reinvestment risk duration > horizon = price risk

Spot Rate for a Zero Coupon Bond

today's rate for a zero coupon bond until maturity

Duration

weighted average time of each CF duration decreases as YTM decreases


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