FIN 403 Exam 3
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