Fixed Income LIII Practice Test (Answered)
Verified Solution
Expected Excess Return
(s x t) - (changeins x SD) - (t x p x l)
Interpolated Yields
1) Your Bond Interest Rate = (Wi x Duration Bond A) + ((1 - Wi) x Duration Bond B)
2) (w)(int. rate) + (1-w)(int. rate)
3) Your Bond Int. Rate - weighted average interest rate
Empirical Duration
Duration determined by regression analysis of the historical relationship between
security prices and yields
Investment-Grade - Default-Risk and Credit Spread
Lower and narrower compared to IG
Narrowing of Spreads During Market Expansion
Narrow more for HY relative to IG, meaning outperformance in rising rate environment
(lower empirical duration)
Carry Trade
Executed by selling bonds with low yields and investing in bonds with high yields
thereby earning a yield advantage when positions are carried over the investment
period
Carry Trade - YC Steepness
Base your carry trade off of the STEEPER YC
Intermarket Carry Trade - Duration Neutral
The carry trade will have positive duration and will need to be hedged by SELLING
long-dated bonds in the OPPOSITE market and BUYING ST Bonds in that market (i.e.,
if your carry trade is in US, carry out the neutral duration in the other state)
Intermarket Carry Trade - Cash Neutral
Buy the same market value in one market that is sold in the other
- If cash neutral, NO NEED to hedge currency exposure
Expected Return - Formula
Income Yield + Rolldown Return + Change in price due to changes in yield and credit
spread +/- credit g/l +/- Currency g/l
Rolling Yield - Formula
Income Yield + Rolldown Return
Income Yield - Formula
Annual Coupon / Current Bond PORT Price
Rolldown Return - Formula
(Bond price end of horizon period - Bond price beginning of horizon period) / (bond price
beginning of horizon period)
Roll-Down Return - Assumption
Based on projected price change if YC DOES NOT CHANGE
, Changes in Yield and Credit Spread - Formula
(-SD x Change in spread) + (.5 x convexity x change in spread^2)
Leveraged Return - Formula
Rl + (Vb / Ve)(Rl -Rb)
Increase Duration With Swap
Receive Fixed, Pay Floating
- Borrowing sort rates to invest at longer rates
Futures on Fixed Income Securities
Leverage, taking long positions in FI futures allows for upside of buying that notional
amount of bonds with small initial outlay to post margin
Repos - Leverage
Way to borrow the funds necessary to leverage a PORT
- Substance of transaction is borrowing funds using securities as collateral for loan
Fixed Income - 3 Characteristics
- Predictable cash flows can be used to meet recurring payout needs
- Diversification due to low correlation with equities
- Inflation hedging low unless have floating rate not bonds
FI Correlation to Equity in Downturns
Even MORE NEGATIVE during downturns
- Investors flee to high-quality government bonds, driving up prices and driving down
yields
Floating-Rate Bonds - Inflation
Coupon payments increase with increasing inflation
Multiple Liabilities Immunization - 2 Things Needed
- MATCH BPV of PORT and Time Horizon
- ASSET convexity somewhat higher than liabilities to hedge against CURVE
RESHAPING
Can Structural Risk be Completely Removed from PORT?
YES, a zero-coupon bond would provide perfect immunization with no structural risk for
a single liability if the maturity of the zero-coupon bond is set to the date of the liability
Cash-Flow Matching Strategy - Investment Universe
LIMITS asset selection to only those with cash flows matching liability dates
- LEAST FLEXIBLE in bond selection
Cash-Flow Matching - Return
Generally locks in LOWEST RETURN
Enhanced Indexing
Fewer securities than the index but matches the primary risk factors present in the index
Value-Weighted Index - FI
Assigns larger share of the index to issuers with larger amounts of outstanding debt
- Investors tracking the index have more exposure to those highly levered borrowers
- BUMS PROBLEM - negative correlation between issuer's credit worthiness and
leverage
Immunization - Matching...
Verified Solution
Expected Excess Return
(s x t) - (changeins x SD) - (t x p x l)
Interpolated Yields
1) Your Bond Interest Rate = (Wi x Duration Bond A) + ((1 - Wi) x Duration Bond B)
2) (w)(int. rate) + (1-w)(int. rate)
3) Your Bond Int. Rate - weighted average interest rate
Empirical Duration
Duration determined by regression analysis of the historical relationship between
security prices and yields
Investment-Grade - Default-Risk and Credit Spread
Lower and narrower compared to IG
Narrowing of Spreads During Market Expansion
Narrow more for HY relative to IG, meaning outperformance in rising rate environment
(lower empirical duration)
Carry Trade
Executed by selling bonds with low yields and investing in bonds with high yields
thereby earning a yield advantage when positions are carried over the investment
period
Carry Trade - YC Steepness
Base your carry trade off of the STEEPER YC
Intermarket Carry Trade - Duration Neutral
The carry trade will have positive duration and will need to be hedged by SELLING
long-dated bonds in the OPPOSITE market and BUYING ST Bonds in that market (i.e.,
if your carry trade is in US, carry out the neutral duration in the other state)
Intermarket Carry Trade - Cash Neutral
Buy the same market value in one market that is sold in the other
- If cash neutral, NO NEED to hedge currency exposure
Expected Return - Formula
Income Yield + Rolldown Return + Change in price due to changes in yield and credit
spread +/- credit g/l +/- Currency g/l
Rolling Yield - Formula
Income Yield + Rolldown Return
Income Yield - Formula
Annual Coupon / Current Bond PORT Price
Rolldown Return - Formula
(Bond price end of horizon period - Bond price beginning of horizon period) / (bond price
beginning of horizon period)
Roll-Down Return - Assumption
Based on projected price change if YC DOES NOT CHANGE
, Changes in Yield and Credit Spread - Formula
(-SD x Change in spread) + (.5 x convexity x change in spread^2)
Leveraged Return - Formula
Rl + (Vb / Ve)(Rl -Rb)
Increase Duration With Swap
Receive Fixed, Pay Floating
- Borrowing sort rates to invest at longer rates
Futures on Fixed Income Securities
Leverage, taking long positions in FI futures allows for upside of buying that notional
amount of bonds with small initial outlay to post margin
Repos - Leverage
Way to borrow the funds necessary to leverage a PORT
- Substance of transaction is borrowing funds using securities as collateral for loan
Fixed Income - 3 Characteristics
- Predictable cash flows can be used to meet recurring payout needs
- Diversification due to low correlation with equities
- Inflation hedging low unless have floating rate not bonds
FI Correlation to Equity in Downturns
Even MORE NEGATIVE during downturns
- Investors flee to high-quality government bonds, driving up prices and driving down
yields
Floating-Rate Bonds - Inflation
Coupon payments increase with increasing inflation
Multiple Liabilities Immunization - 2 Things Needed
- MATCH BPV of PORT and Time Horizon
- ASSET convexity somewhat higher than liabilities to hedge against CURVE
RESHAPING
Can Structural Risk be Completely Removed from PORT?
YES, a zero-coupon bond would provide perfect immunization with no structural risk for
a single liability if the maturity of the zero-coupon bond is set to the date of the liability
Cash-Flow Matching Strategy - Investment Universe
LIMITS asset selection to only those with cash flows matching liability dates
- LEAST FLEXIBLE in bond selection
Cash-Flow Matching - Return
Generally locks in LOWEST RETURN
Enhanced Indexing
Fewer securities than the index but matches the primary risk factors present in the index
Value-Weighted Index - FI
Assigns larger share of the index to issuers with larger amounts of outstanding debt
- Investors tracking the index have more exposure to those highly levered borrowers
- BUMS PROBLEM - negative correlation between issuer's credit worthiness and
leverage
Immunization - Matching...
