Fixed Income Flashcards

Question

Structured Based Issues

Answer 1

1. **Callable Bonds** - interest rates decline, underperforms 1. Creates negative convexity due to the limit on price appreciation 2. **Sinking Bonds** - has callable feature but isser forced to "call" at the specified time. Could benefit bond holder 3. **Putable Bonds** - very scarce and illiquid

Answer 2

R_P = R_i + [L/E) \* (R_i - cost to borrow)] More leverage = higher variability of returns Example: Portfolio = 100M, $70M of which is borrowed. Return = 6%, cost of borrowing = 5%. 6% + [(70/30) \* (6%-5%)] = 8.33%

Answer 3

D_E = [(D_i)(Notional) - (D_L)(L)] / E Example: Portfolio = 100M, $70M of which is borrowed. Duration = 5.0, Duration of borrowing = 1.0. D_E = (5.0)(100) - (1.0)(70) / 30 = 14.33

Answer 4

**Definition:** a collaterilized loan **Interest Calculation:** borrowed \* r \* (days/360) **Risks:** credit risk

Answer 5

1. **Credit** risk 2. **Quality** of collateral 3. **Availability** of collateral (more difficult to obtain ↓ rate) 4. **Physical** delivery = lower rate 5. **Repo** term (Term ^, rate ^) 6. **Fed** funds rate

Answer 6

Duration is not accurate for l_arge yield changes_ or bonds with _negative convexit_y. Other risk measures are: **_Risk Measure Problems_** * Standard Deviation Not normally distributed * Semivariance\* (return stats below target) Less accurate * Shortfall Risk (probability below target) Degree of loss ignored * Value at Risk Degree of loss ignored \*Semivariance is the left side of the tail

Answer 7

N_f = [(D_T - D_P) \* V_P / D_CTD \* P_CTD] \* CF \* Yield Beta **Note:** Yield Beta = 1 unless specified Example: $50M portfolio, D = 7.51, D_T = 8.5 Futures priced at 110,000 with D of 7.6, CF = .98 of contracts = [(8.5 - 7.51) \* 50M / 7.60 \* 110,000] \* 0.98 \* 1.0 = 58.03

Answer 8

**Basis** = spot price - futures delivery price **Basis risk** is the variability of the basis (spot vs future). Makes hedging results change **Cross hedge** **risk** = underlying security not iidentical to asset being held (Using T-bond futures to hedge corporate bonds)

Answer 9

Receiving fixed = Higher duration Paying fixed = lower duration Always add duration of what you **RECEIVE** Subtract duration that replicates what you **PAY** _There are options on bond prices AND interest rates_ Example: receive fixed and pay floating Add duration of fixed and subtract duration of floating

Answer 10

option delta \* D_underlying \* (P_underlying / P_option) buy calls = ^ duration buy puts = lower duration (have negative delta and duration)

Answer 11

Credit put option on price = receive if price declines Credit call option on spread = receive if the spread widens **Binary credit option:** structured with a _specified event_ _No payoff_ if the event doesn't occur Example: 1 year credit put option is purchased on a AA bond 10M if falls below investment grade, Strike = 92, option premium = 100,000, Bond rating drops to BB, price declines to 87.50. Calculate payoff (92 - 87.50)/100 \* 10,000,000 = 450,000

Answer 12

Used for credit and spread events **_Credit Spread & Credit Forward_** (actual spread - strike spread) \* notional \* risk factor Example: 1,000 bonds, MV of $1M, Spread is 200 bps. Manager buys option; strike = 250 bps, notional = $1M, RF = 10 Option matures and bond price is 900, implying spread of 350. Value = (0.035 - 0.025) \* $1M \* 10 = 100,000

Answer 13

Same as credit option but no premium Example: Hi-Fi bonds trade at a 200 bp spread. Buys a 6-month credit forward on $5M par at the current spread with a risk factor of 4.3. Calculate payoff if spread is 150 bp OR 300 bp. Then calculate max loss 150 bp: (.015 - 0.20)(4.3)(5,000,000) = 107,500 paid (none received) 300 bp: (0.030 - 0.020)(4.3)(5,000,000) = 215,000 received max loss = (0.00 - 0.020)(4.3)(5,000,000) = 430,000 paid

Answer 14

One time payment for event protection Example: 3 yr CDS on $20M bond, swap premium 50 bps, event = fall below BBB After 6 months bond falls to BB and 80% of par. Swap premium = .005 \* $20M = $100,000 Payment = (1 - 0.8) \* $20M = $4M

Answer 15

1. Market Selection 2. Currency Selection - hedged or unhedged 3. Duration Management 4. Sector Selection 5. Credit Analysis

Answer 16

**_▲ in Yield_** %▲ = duration x ▲y x B **_Duration_** weight \* duration \* beta **Remember:** standardized duration is duration \* beta Example: 20% of GBP bond portfolio is invested in German bonds, D = 6, country beta = 0.42. Calculate the duration contribution: Duration contribution when UK rates change: (6)(0.42) = 2.52 Duration contribution to fund: (0.2)(2.52) = 0.504

Answer 17

Higher yielding currency depreciates. **IRP:** F = S₀(1 + R_D / 1 + R_F) OR R_{f foreign} - R_{f domestic} Example: US 7%, Euro 5%, exchange is 2.35 $/E 2.35(1.07 / 1.05) = 2.395 Then 2.395 / 2.35 = 1.91% premium EUR R_f= 5%, GBP R_f = 2.5%. Domestic = GBP 5 - 2.5 = 2.5%, EUR is expected to dep. 2.5% against GDP

Answer 18

Step One - Best market is highest excess return (R_M - R_f) Step Two - Best Currency: Compare expected change (higher is better)

Answer 19

**Forward Differential:** F_d,f = (F - S₀) / S₀ ## Footnote Discount/Premium Hedged Return If Foreign \> Domestic discount negative If Foreign \< Domestic premium positive

Answer 20

* **Forward hedge** - used to eliminate currency risk * **Proxy hedge** - contract with a similar currency * **Cross Hedge** - sell foreign currency for a third countries currency (speculation) Currencies with higher return over R_f will have higher return Example: UK investor buys CAD bond Forward hedge: Sell CAD forward to buy GBP Proxy hedge: Sell USD forward to buy GBP Cross Hedge: Sell CAD forward to buy JPY

Answer 21

bps / **-**duration and **-**bps / **-**duration Make sure to breakdown the bps per quarter Example: Domestic 7.65%, duration 6.5 Foreign 6.85%, duration 5.3 Holding period 6 months ``` Domestic = 80 bps better yield, 20 per quarter ▲y_domestic = -0.40% / -6.5 = 0.06% ▲y_foreign = 0.40 / -5.3 = -0.08% ``` foreign bond would need to decrease 8 bps to wipe out its yield advantage or domestic increase by 6 bps

Answer 22

**_Pros_** 1. Diversification 2. Increased quality/resiliency in sovereign bonds **_Cons_** 1. EM Corporates are more risky 2. Highly volatile 3. Lack of trasparency 4. Political risk/legal systems 5. Negative skewness in returns

Answer 23

1. Style Analysis - sources of risk and return 2. Selection Bets - attribution 3. Investment Process 4. Alpha Correlations

Answer 24

Assume that the short-term interest rates are 1.6 percent in Japan and 2.7 percent in Canada. Yen will appreciate 1.5% against CAD and 0.5%. Hedge or not? 2.7 - 1.6 = 1.1 anything above 1.1 should NOT be hedged

Answer 25

**Hedged:** (Forward / spot) - 1 **Non Hedged:** (Forecast / spot) - 1 If only given one, take the difference if the R_f for hedged. Example: Rf = 1.8%EUR, 4%US Forecast = 1.97EUR/1 US, Spot = 2EUR/1 US EUR YTM = 4.30, US YTM = 7.5% (1. 97 / 2) - 1 = -1.5% Not hedged 4. 30 - 7.5 = -2.2% Hedged Would NOT hedge.

Answer 26

**_Economy YC shift Trade to Make Reasons_** Stronger Upward Less quality ↑ liquidity ↑ change for an update Stronger Upward ↓ duration Lessen impact of ↓price

Fixed Income Flashcards

(50 cards)