FI

Question 1

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

Answer 1

Diversification
Cash flows
Hedge against inflation

Question 2

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

Answer 2

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

Question 3

What factors affect bond market liquidity?

Answer 3

Time since issuance, credit quality,

Question 4

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

Answer 4

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

Question 5

What is the roll yield in modeling bond expected return

Answer 5

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

Question 6

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

Answer 6

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

Question 7

Name 4 ways to get leverage in a fixed income portfolio

Answer 7

Futures
Repos
Swaps
Security lending

Question 8

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

Answer 8

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

Question 9

How would a swap lever a portfolio

Answer 9

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

Question 10

How does a repo work

Answer 10

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

Question 11

How does security lending effect a portfolio return

Answer 11

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

Question 12

How does security lending and repo differ

Answer 12

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

Question 13

Why might someone borrow a security in a repo agreement

Answer 13

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

Question 14

Differences between a barbell and bullet portfolio when managing liabilities?

Answer 14

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

Question 15

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

Answer 15

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

Question 16

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

Answer 16

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

Question 17

What is a positive butterfly shift?

Answer 17

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

Question 18

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

Answer 18

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

Question 19

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

Answer 19

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

Question 20

Advantages of immunization strategies of managing a liability

Answer 20

Protect against IR risk

Provides flexability to activley manage portfolio

Question 21

disAdvantages of immunization strategies of managing a liability

Answer 21

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

Question 22

Formula for duration effect on portfolio

Answer 22

Duration effect is=

% change yield * Duration = % change in price

Question 23

Convexity formula for change in price in portfolio

Answer 23

Convexity * .5 * Change in yield ^2

Question 24

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

Answer 24

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

Question 25

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?

Answer 25

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.

Question 26

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

Answer 26

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

Question 27

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?

Answer 27

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.

Question 28

What is contingent immunization

Answer 28

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.

Question 29

What is a cash flow matching portfolio in liability investing?

Answer 29

Pretty much matching the cash flows to liabilities due -

Question 30

Advantage and disadvantage of cash flow matching strategy

Answer 30

Adv - no need to worry about interest rates | Dis - More bonds ussually needed in portfolio, more transaction costs

Question 31

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

Answer 31

Derivatives, SWAP, Future, swaptions etc.

Question 32

Formula for number of contracts Needed to fill duration gap

Answer 32

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

Question 33

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

Answer 33

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

Question 34

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

Answer 34

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

Question 35

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

Answer 35

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

Question 36

Can you use swaptions to increase duration exposure if needed?

Answer 36

Yes

Question 37

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

Answer 37

Yes, both

Question 38

WHat is a laddered portfolio for liability driven investing?

Answer 38

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

Question 39

Structurual risk = convexity

Answer 39

No answer

Question 40

What is enhanced indexing?

Answer 40

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

Question 41

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

Answer 41

Full replication ETF Managed fund Derivatives

Question 42

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

Answer 42

Less costly upfront Exposure to less liquid securities Counterparty risk

Question 43

Which sort of duration does an immunizing portfolio use?

Answer 43

MACUALY duration

Question 44

Explain what model risk is?

Answer 44

When your model of the future may be wrong

Question 45

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

Answer 45

Duration - it must be low

Question 46

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

Answer 46

Hugher

Question 47

Which has more convexity - laddered, bullet or barbell portfolio

Answer 47

Barbell, then laddered

Question 48

Immunization protects against....

Answer 48

reinvestment and price risk

Question 49

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

Answer 49

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

Question 50

How do you sell convexity in fixed income

Answer 50

Sell calls and puts

Question 51

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

Answer 51

Barbell - convexity

Question 52

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

Answer 52

Barbell - highest dispersion of cash flows

Question 53

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

Answer 53

Bullet

Question 54

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

Answer 54

YES

Question 55

Does buying a call and put long convexity?

Answer 55

yes

Question 56

How does selling a MBS effect convexity

Answer 56

Increases it

Question 57

Does a selling callable bond have positive or negative convexity

Answer 57

Negative

Question 58

What is the relationship between yield and convexity and why

Answer 58

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

Question 59

Steeping yield curve - best strategy in fixed income>

Answer 59

Bullet

Question 60

What is a butterfly trade

Answer 60

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

Question 61

Carry trade is?

Answer 61

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

Question 62

Duration exposure formula - how to alter it

Answer 62

Basis Point Value of Liability - BPV Target / BPV Future BSV = Exposure * Duration * .0001

Question 63

If interest rates decrease, which sort of option protects you

Answer 63

Put

Question 64

If interest rates decrease, which sort of option protects you

Answer 64

Put

Question 65

Does convexity mitigate structural risk?

Answer 65

No - it is the measure of structural risk

Question 66

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

Answer 66

Loss severity * prob of deafult

Question 67

Spread duration is measured against...

Answer 67

treasuries

Question 68

Floating rate bonds have a duration of

Answer 68

close to 0

Question 69

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

Answer 69

Credit. Low duration = low ir risk

Question 70

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

Answer 70

High yield is credit risk

Question 71

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

Answer 71

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

Question 72

Why are HY bonds less liquid

Answer 72

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

Question 73

Richness and cheapness effect in bonds, explain

Answer 73

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

Question 74

What is the G spread

Answer 74

Difference between our bond and treasury rates

Question 75

What is i spread and one adv and disadv

Answer 75

Interest rate swaps v our bond. All time periods. Not good for pricing HY bonds - ussually for high credit qual securities

Question 76

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?

Answer 76

Prague, priced lower because of higher OAS

Question 77

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

Answer 77

Liquidity risk and date of issuance and seniority of debt

Question 78

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

Answer 78

ETF, swaps, derivatives, CDS

Question 79

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

Answer 79

HY bonds

Question 80

OAS is like

Answer 80

Credit risk

Question 81

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

Answer 81

IR risk

Question 82

Are corporate markets more or less liquid than treasuries

Answer 82

LESS LIQUID

Question 83

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

Answer 83

Goes down bad

Question 84

How to manage liquidity risk in FI?

Answer 84

Use cash instead Derivaties ETFs Hold more liquid securities

Question 85

Convexity is good for …..

Answer 85

Parellel shifts only

Question 86

OAS - expected loss on a credit bond

Answer 86

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

Question 87

Rolldown return formula

Answer 87

Price t1 - Price t0 / Price t0 + Coupon yield

Question 88

What would a buy and hold strategy do to your duration

Answer 88

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

Question 89

What does increasing yields mean for the US economy and why

Answer 89

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