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CFA iii > FI > Flashcards

FI Flashcards

1
Q

Why would you add fixed income to a portfolio (3 reasons)

A

Diversification
Cash flows
Hedge against inflation

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2
Q

Why does adding fixed income diversify your portfolio? Imagine against an equity portfolio

A

Because, traditionally, the correlation between equity and fixed income is less that one, meaning that the combination of assets will create diversification benefits.

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3
Q

What factors affect bond market liquidity?

A

Time since issuance, credit quality,

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4
Q

What are the 5 (yes 5) components of bond returns

A 
Coupon payment
Roll yield
Yield changes (IR and Credit)
Credit deterioration
Currency yield
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5
Q

What is the roll yield in modeling bond expected return

A

It ASSUMES an upward sloping yield curve, and as the TIME TO MATURITY decreased, the price of the bond INCREASES, so you gain on the increase in price of the bond.

If the yield curve is flat, it is dependent on whether the bond was issued at par or premium etc, to determine how the bond is pulled toward par as the time to maturity decreases

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6
Q

What are the 2 weaknesses to the 5 components of modeling bond expected return

A
  1. Assumes duration and convexity are an appropriate measure of bond price movements - these are more like approximations
  2. Cheapness/richness effect pricing bonds - not all factors are taken into consideration when pricing a bond off the yield curve - they could be cheap or rich dependent on other factors
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7
Q

Name 4 ways to get leverage in a fixed income portfolio

A

Futures
Repos
Swaps
Security lending

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8
Q

Explain what leverage is in a fixed income portfolio (look at the answer)

A

It is increasing the risk in the portfolio, ussually with borrowed cash, to increase returns

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9
Q

How would a swap lever a portfolio

A

It gives you a long and short exposure to certain charecteristics, which could increase the returns on your portfolio.

If you think IR will increase and you want to gain off that, then you will get a recieve floating swap

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10
Q

How does a repo work

A

It is a repurchase agreement. You LEND a security to someone for some cash which you can put to work, then you pay that cash back and get your security back - this can work on both sides of the transaction

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11
Q

How does security lending effect a portfolio return

A

It is when you lend a security to someone else for a fee of x% - so you automatically gain on that

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12
Q

How does security lending and repo differ

A

With security lending, there is no set period, whereas a repo is ussually over a month or overnight or 10 days.

Also, in security lending, the lender can recall the security whenever they like

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13
Q

Why might someone borrow a security in a repo agreement

A

They may need it to cover a short sale they have entered into, or to hedge a short term position or to bring their duration back into like

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14
Q

Differences between a barbell and bullet portfolio when managing liabilities?

A

Barbell portfolio is when you have a 2 asset portfolio that has differing maturities which on average MATCHES that of your liability.

Bullet portfolios are just a zero coupon payment that match your liability

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15
Q

Do you want convexity in your portfolio when trying to manage a liability

A

NO WAY JOSE. YOU DONT. Convexity = dispersion which is not what you want when managing a liability

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16
Q

If there is a steepening of the yield curve, how does that effect your bullet and barbell portfolios?

A

Barbells rekt. Why? Becuase they are more exposed to long duration shifts as they have longer dated bonds in their portfolios, meaning thier value GO DOWN when long term key rates go UP

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17
Q

What is a positive butterfly shift?

A

It is short term up, mid term down and long term yields go up

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18
Q

What are 3 things you want/need to manage a liability. 3 charecterisitcs that must be met

A

ASSETS MUST BE MORE THAN LIABILTIIES
CONVEXITY MUST BE LOW
THe duration of the portfolio must match that of the liability

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19
Q

If there is a one time parellel shift in the yield curve, what sort of portfolio will outperform - which charecteristic and why

A

The one with more convexity, on the up or downside, as it provides price support on the downside while increasing upside on a down shift

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20
Q

Advantages of immunization strategies of managing a liability

A

Protect against IR risk

Provides flexability to activley manage portfolio

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21
Q

disAdvantages of immunization strategies of managing a liability

A

Can NOT hedge out structural risk (non parellel shifts in yield curve)
Can not hedge out credit and deafult risk
Costs associated with rebalancing

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22
Q

Formula for duration effect on portfolio

A

Duration effect is=

% change yield * Duration = % change in price

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23
Q

Convexity formula for change in price in portfolio

A

Convexity * .5 * Change in yield ^2

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24
Q

What are the 3 conditions that MUST be met to create a portfolio to immunize MULTIPLE liabilities at once

A

Portfolio MV is more than the PV of liabilities
Higher convexity in the assets
The disparity/range of duration is larger for the assets than the liabilities

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25
Q

To create a portfolio to immunize multiple liabilities, you need to have a duration range that exceeds that of the liabilitities, what does this mean? And why would you do it?

A

So, if you have liabilities with durations of 3 and 5 (50/50 split), you want assets that have a duration of 2 and 6 - this means that if the yield curve changes up or down, you are protected.

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26
Q

Lets imagine i have a portfolio worth 60m dollars and a liability worth $84 million, can i immunize?

A

NO WAY, the PV of the portfolio must equal or exceed that of the liabilities

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27
Q

I have a portfolio and multiple liabilities.

The 2 asset portfolio has an average duration of 5, with durations of those assets of 4 and 7.

The 2 liabilities have a duration of 6 and a range of durations of 4 and 8.

What is wrong with this portfolio to immunize?

A

2 things. The durations DO NOT MATCH.

The range of the durations of the PORTFOLIO do not exceed that of the liabilities. The range of durations on the assets must be wider.

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28
Q

What is contingent immunization

A

It is when you DO NOT HAVE TO PASSIVELY immunize the portfolio, you can actively manage it IF, and ONLY IF, the portfolio does not drop below a pre-defined level - ussually the PV of the liabilities if the portfolio were managed using a passive immunization strategy.

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29
Q

What is a cash flow matching portfolio in liability investing?

A

Pretty much matching the cash flows to liabilities due -

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30
Q

Advantage and disadvantage of cash flow matching strategy

A

Adv - no need to worry about interest rates

Dis - More bonds ussually needed in portfolio, more transaction costs

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31
Q

What do you use to manage a duration gap in portfolio?

A

Derivatives, SWAP, Future, swaptions etc.

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32
Q

Formula for number of contracts Needed to fill duration gap

A

(Value of Liability * .0001 * Duration) - (Value of Asset * .0001 * Duration)
/
Basis point value of contract

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33
Q

If you think interest rates will increase, and you currently have a duration gap whereby you have less duration in a portfolio than a liability you would like to match, would you over or under hedge

A

UNDER. If you think IR increase, then ir increase = more downward pressure on bond prices. You do not want this exposure

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34
Q

If you have less duration than the liability you are looking to immunise, how would you use a swap

A

You would enter a recieve fixed swap, so you are recieving the duration

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35
Q

Formula for notional amount of swap to hedge duration of a liability

A

Notational GAP (Value of Liability- Assets) / Duration fixed (this is what you are getting, so it is positive) MINUS Duration floating leg of swap

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36
Q

Can you use swaptions to increase duration exposure if needed?

A

Yes

37
Q

Does immunization cancel out price AND coupon reinvestment risk? For when interest rates increase or decrease>

A

Yes, both

38
Q

WHat is a laddered portfolio for liability driven investing?

A

It is when you spread your assets out like a ladder across maturities. It is good for liquidity and diversification

39
Q

Structurual risk = convexity

A

No answer

40
Q

What is enhanced indexing?

A

It is like stratified sampling - taking on risk is certain buckets to match an index

41
Q

What are 4 ways to get exposure to a fixed income index?

A

Full replication
ETF
Managed fund
Derivatives

42
Q

Advantages and disadvantages of using swap to get exposure to fixed income index

A

Less costly upfront
Exposure to less liquid securities
Counterparty risk

43
Q

Which sort of duration does an immunizing portfolio use?

A

MACUALY duration

44
Q

Explain what model risk is?

A

When your model of the future may be wrong

45
Q

If i have to select an index for an old workforce pension plan - which portfolio charecteristic should i consider

A

Duration - it must be low

46
Q

The convextity of an asset to a liability must be higher or lower

A

Hugher

47
Q

Which has more convexity - laddered, bullet or barbell portfolio

A

Barbell, then laddered

48
Q

Immunization protects against….

A

reinvestment and price risk

49
Q

Imagine a completly stable IR environment, IR is not going to change from its current upward slope - what are the FOUR 4 strategies to earn yield

A 
Buy and hold long dated bonds
Ride the yield curve
Carry trade (Borrow short, invest long)
Sell convexity
50
Q

How do you sell convexity in fixed income

A

Sell calls and puts

51
Q

If there is going to be a parellel shift in the yield curve, which portfolio performs best - barbell, bullet, ladder

A

Barbell - convexity

52
Q

Which portfolio barbell, bullet, ladder has the highest convexity and why

A

Barbell - highest dispersion of cash flows

53
Q

For a steepening of the yield curve, which portfolio performs best barbell, bullet, ladder

A

Bullet

54
Q

If we expect changes in the yield curve, do we want convexity

A

YES

55
Q

Does buying a call and put long convexity?

A

yes

56
Q

How does selling a MBS effect convexity

A

Increases it

57
Q

Does a selling callable bond have positive or negative convexity

A

Negative

58
Q

What is the relationship between yield and convexity and why

A

More convexity = lower yield

Why? Everyone wants convexity to hedge against non parellel ir shifts, so they buy up the convex instruments, driving up their price and subsequently reducing their yield

59
Q

Steeping yield curve - best strategy in fixed income>

A

Bullet

60
Q

What is a butterfly trade

A

Longing and shorting a bullet and barbell at the same time to make the trade duration neutral, but also getting extra duration exposure to key rates

This is a levered position

61
Q

Carry trade is?

A

Borrowing in low interest rate currency, borrowing in high IR currency ASSUMING that high IR currency will depreciate less than market expects

62
Q

Duration exposure formula - how to alter it

A

Basis Point Value of Liability - BPV Target / BPV Future

BSV = Exposure * Duration * .0001

63
Q

If interest rates decrease, which sort of option protects you

A

Put

64
Q

If interest rates decrease, which sort of option protects you

A

Put

65
Q

Does convexity mitigate structural risk?

A

No - it is the measure of structural risk

66
Q

Credit risk is X*Y. What are x and y

A

Loss severity * prob of deafult

67
Q

Spread duration is measured against…

A

treasuries

68
Q

Floating rate bonds have a duration of

A

close to 0

69
Q

Is a floating rate corp bond more suseptible to IR risk or credit risk

A

Credit. Low duration = low ir risk

70
Q

IG v High yield - which is more suseptible to IR risk and credit risk

A

High yield is credit risk

71
Q

Interest rates and credit risk have what sort of correlation and why

A

Negative. If the world is doing well, IR will increase to things do NOT overcook, and i things are doing well, credit risk (risk of deafult) will go down

72
Q

Why are HY bonds less liquid

A

High buy sell spread for dealers
More regulation for dealers to keep on books
Less deep market - less HY bonds out there
Low turnover for HY portfoliosR

73
Q

Richness and cheapness effect in bonds, explain

A

This is a paradigm that the YC does NOT take all factors into consideration when pricing a bond

74
Q

What is the G spread

A

Difference between our bond and treasury rates

75
Q

What is i spread and one adv and disadv

A

Interest rate swaps v our bond.

All time periods.

Not good for pricing HY bonds - ussually for high credit qual securities

76
Q

Imagine we have 2 bonds identical in every way EXCEPT one is priced at a higher OAS that the other (Prague is higher, Guy is lower) - which do we buy?

A

Prague, priced lower because of higher OAS

77
Q

What beyond the credit curve must we take into consideration when buying a bond?

A

Liquidity risk and date of issuance and seniority of debt

78
Q

How would i get exposure to a bond or risk factor without buying the bond itself

A

ETF, swaps, derivatives, CDS

79
Q

Top down Fixed income analysis, if i think markets are about to turn around out of a downturn, i should buy ….

A

HY bonds

80
Q

OAS is like

A

Credit risk

81
Q

If i change my portfolio allocations to have less duration, i am concerned with

A

IR risk

82
Q

Are corporate markets more or less liquid than treasuries

A

LESS LIQUID

83
Q

If there is a flight to quality, what happens to HY markets?

A

Goes down bad

84
Q

How to manage liquidity risk in FI?

A

Use cash instead
Derivaties
ETFs
Hold more liquid securities

85
Q

Convexity is good for …..

A

Parellel shifts only

86
Q

OAS - expected loss on a credit bond

A

Pretty much equals the yield on the bond - the higher (compared to others) the better

87
Q

Rolldown return formula

A

Price t1 - Price t0 / Price t0 + Coupon yield

88
Q

What would a buy and hold strategy do to your duration

A

Increase - buy and hold indicates your think the yield curve will be unchanged - thus buying a longer dates bond , and unchanged yield curve = collect more coupon

89
Q

What does increasing yields mean for the US economy and why

A

Increasing yeidls means there is LESS DEMAND FOR THE LOW RISK TREASURIES, meaning people are more willing to punt on other things which means confidence

CFA iii (11 decks)

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