MIP 6 - Fixed Income Portfolio Management

Question 1

What are the 4 key activities in the investment management process?

Answer 1

1. Setting the investment objective (return, risk, and constraints)
2. Developing and implementing a portfolio strategy
3. Monitoring the portfolio
4. Adjusting the portfolio

Question 2

List the 5 strategies for managing FI portfolio against a bond market index, from the least tracking error to most

Answer 2

1. Pure bond indexing (or full replication)
   
   • Attempts perfect match (own all bonds in index)
2. Enhanced indexing by matching primary risk factors
   
   • ​​Primary risk factors: interest rate level, yield curve twists, and spreads
3. Enhanced indexing by small risk factor mismatches
   
   • ​Match duration, while actively managing smaller risk factors (sector, quality, term structure etc.)
4. Active management by larger risk factor mismatches
5. Full-blown active management (most aggressive mismatches)

Question 3

Describe disadvantages of Pure Bond Indexing in FI portfolio management

Answer 3

• Very difficult and rarely done in practice
• Expensive and inefficient
• Many bonds in an index are illiquid and rarely traded

Question 4

Describe advantages of Enhanced Indexing by matching primary risk factors in FI portfolio management

Answer 4

• Lower cost than pure indexing – uses only a sample of the bonds in the index
• Still affected by broad market events (due to primary risk factor match)
• Manager can enhance yield by selecting under-valued bonds

Question 5

Describe disadvantages of Enhanced Indexing by matching primary risk factors in FI portfolio management

Answer 5

more tracking error with the index

Question 6

List the 3 reasons for using indexing

Answer 6

1. Lower fees than managed accounts
2. Outperforming an index (after costs) is difficult to do consistently
3. Excellent diversification

Question 7

Describe the risk factors to consider when choosing an index (in pure and enhanced FI strategies)

Answer 7

1. Market value risk of portfolio should be similar to benchmark
   
   • Longer portfolios tend to have higher MV risk (higher sensitivity to interest rate changes)
2. Income risk should be similar to benchmark
   
   • Longer portfolios tend to have less income risk (more stability)
3. Liability framework risk – should match A/L investment characteristics
   
   • Use longer bonds for longer liabilities

Question 8

Yield Curve Risk Factors (indexing FI strategies)

Answer 8

Yield curve = major source of risk for most bonds

1. Parallel shifts account for 90% of bond value changes
2. Twists (points move in different directions)
3. Other curvature changes

Question 9

Describe the 3 risks when assessing an index’s
sensitivity (indexing strategies)

Answer 9

1. Interest rate risk – changes in level of interest rates (parallel shifts)
   
   • Largest risk source (90%)
2. Yield curve risk – changes in yield curve shape (twists, curvature)
3. Spread risk – changes in spread over Treasuries (credit risk)

Question 10

Cell-matching a.k.a. stratified sampling Indexing (Pure and Enhanced)

Answer 10

divides the benchmark into risk cells

• Manager chooses bonds from each cell to match the overall index

Question 11

Multi-factor model Indexing (Pure and Enhanced)

Answer 11

makes use of a set of factors that drive bond returns

Question 12

List the primary bond risk factors.

Answer 12

1. Duration and convexity – price sensitivity to parallel yield shifts
2. Key rate duration and present value distribution of cash flows
3. Sector and quality percent
4. Sector duration and contribution
5. Quality (credit) spread duration contribution
6. Sector/coupon/maturity cell weights
7. Issuer exposure (manage event risk)

Question 13

Definition and challenge of Effective duration

Answer 13

• Measures the linear (first order) sensitivity to small parallel shifts in interest rates
• Problem: Perfectly parallel shifts in the yield curve are rare

Question 14

Convexity adjustment

Answer 14

Estimates additional price change due to larger yield curve shifts that comes from curvature (second order effects)

Question 15

Key rate duration

Answer 15

Measures the sensitivity to a small change in a single key rate

• Hold all other rates on the yield curve constant except one
• Useful for testing bulltet and barbell strategies

Question 16

Present value distribution of cash flows (Primary bond risk factors) and formula

Answer 16

• Measure sensitivity to non-parallel yield curve changes
• This approach is basically matching the portfolio’s KRDs to the index (i.e. weighting each KRD by the PV of cash flows for that key rate)

Question 17

When is Sector/coupon/maturity cell weights more feasible than convexity matching

Answer 17

when call exposure is a concern

Question 18

Describe tracking risk and its formula components

Answer 18

standard deviation of the portfolio’s active return over time

Question 19

Describe the main disadvantage of using enhanced bond management strategies

Answer 19

add costs –> must be earned on top of a passive return

Question 20

Describe strategies to overcome the high costs of enhanced indexing

Answer 20

1. Lower cost enhancements – reduce trading costs and management fees
2. Issue selection enhancements – attempt to find undervalued securities
3. Yield curve positioning – find consistently mispriced maturities
4. Sector and quality positioning (2 forms)
5. Call exposure positioning – e.g. under-weight in callable bonds if you expect falling interest rates

Question 21

Two strategies of Sector and quality positioning to overcome high costs of enhanced indexing

Answer 21

• Tilt toward short duration corporates
  
  • offer best yield spread per unit of duration risk
• Periodic over- or under-weighting of sectors or qualities
  
  • over-weight on Treasuries if spreads are expected to widen

Question 22

Describe some additional activities that are carried out by active FI managers

Answer 22

1. Exploit index mismatches (based on manager’s expertise)
2. Extrapolate market expectations from market data (e.g. analyze forward rates)
3. Independently forecast inputs (interest rates, volatility, spreads, etc.) and compare with market’s expectations
   
   • Example: manager may believe forward rates are too high -> increases duration mismatch by increasing portfolio duration
4. Estimate relative values of securities to identify areas of under- or over-valuation

Question 23

Define total return with respect to bond returns and list one shortcoming

Answer 23

• takes into account coupon income, reinvestment income, and change in price
• A simple total return estimate does not reflect the risk of being wrong (since it’s only one scenario)

Question 24

Formula and specifications of total return with respect to bond returns

Answer 24

manager must specify the investment horizon, expected reinvestment rate, and expected future price to calculate the total return

Question 25

Describe the purpose and benefits of scenario analysis.

Answer 25

should be performed to see returns under different sets of assumptions 1. Assess distribution of possible outcomes (wider distribution = more risk) 2. Reverse scenario analysis: determine the interest rate movements that would trigger acceptable outcomes 3. Calculate contribution of individual components (e.g. impact of a yield twist) 4. Evaluate merits of entire trading strategy

Question 26

How do amount and timing of liabilities impact FI portfolio strategy?

Answer 26

The more unknown the amount or timing of liabilities, the **less effective passive strategies** are (i.e. active management is needed) * For a typical life or annuity product, the *amount of the liability will be known*, but the *timing will not*. * However, certain products have *unknown amounts and timing* (e.g. a VA GMDB).

Question 27

FI dedication strategies

Answer 27

Specialized fixed-income strategies designed to accommodate specific funding needs of an investor * Includes **immunization** and **cash flow matching**

Question 28

List extensions of Classical single period Immunization

Answer 28

1. Extensions for **non-parallel shifts** 2. Relax the **fixed horizon** requirement 3. **Return maximization** (risk and return trade-offs) 4. **Contingent immunization**

Question 29

Describe Immunization strategies

Answer 29

* Lock in a rate of return over a specified horizon regardless of interest rate changes * Price changes offset with reinvestment income changes

Question 30

Classical Single-Period Immunization and important Characteristics

Answer 30

Results in a fixed-income portfolio that produces an assured return for a specific time horizon 1. Specified time horizon 2. **Assured rate** of **return** over a fixed holding period 3. Insulation from the effects of interest rate changes on the portfolio value at the horizon date

Question 31

List extensions of Cash Flow Matching

Answer 31

1. symmetric 2. combination (horizon) matching

Question 32

List the 2 requirements for classical single period immunization

Answer 32

Requires offsetting price risk and reinvestment risk 1. Portfolio *duration* = liability horizon (duration) 2. *PV* of portfolio *cash flows* = PV of liability cash flows

Question 33

Does investing in a coupon bond matching liability yield and horizon guarantee that the liability will be met?

Answer 33

No...because the bond’s duration will be shorter than the liability

Question 34

Describe 2 ways that a portfolio’s duration can change that will require rebalancing an immunized portfolio

Answer 34

1. As market yields change (*convexity effects*) 2. With the passage of time (duration naturally falls as the bond approaches maturity 3. Also if the liability duration changes Key point: an immunized portfolio must be *continually rebalanced to stay duration-matched* * Must balance transaction costs of rebalancing with the risk of duration mismatches

Question 35

Define the immunized target rate of return.

Answer 35

total portfolio return assuming no change in the term structure Will only equal YTM if the yield curve is flat If yield curve is **positively sloped**, **total return \< YTM** If yield curve is negatively sloped, total return \> YTM

Question 36

Dollar duration (DD) and portfolio DD

Answer 36

* Change in portfolio value (price) for a 100 bps change in yield * Portfolio Dollar Duration = Portfolio Duration \* Portfolio Value \* 0.01 * Also simply the sum of the individual bonds’ DD

Question 37

Bond Duration and Portfolio duration

Answer 37

* % change in bond price P for a 100 bps change in yield * For example, a bond has duration of 5, it means that the bond’s price *will fall 5% if there is a 1% parallel increase in yield curve.* * The duration of a portfolio = price-weighted average of the individual bonds’ durations

Question 38

Formula for portfolio duration

Answer 38

Question 39

Formulas for Macauley and Modified duration

Answer 39

Question 40

Describe the steps required for rebalancing to the desired level of dollar duration.

Answer 40

1. Calculate the new (or current) portfolio DD 2. Calculate the **rebalancing ratio**: * Target DD /New DD - 1 3. Calculate amount of cash needed for rebalancing: * Rebalancing Ratio \* MV of Portfolio

Question 41

what does a rebalancing ratio = 10% mean?

Answer 41

it means each position in the portfolio should be increased 10% get back to the target (or original) DD based on the new yield curve

Question 42

Controlling position in portfolio rebalancing

Answer 42

A particular security in the portfolio that is used to control the portfolio’s DD * Instead of applying a rebalancing ratio to all positions, calculate the adjustment needed for a single position * Derivatives can also be used (covered later)

Question 43

Define spread duration.

Answer 43

measures the change in market value of a risky bond if spread changes by 100 basis points * mainly applicable to bonds/portfolios with credit risk (credit spreads)

Question 44

3 major types of spread that can be used for spread duration

Answer 44

1. **Nominal spread** – spread above the yield of a certain maturity Treasury 2. **Static spread** (zero-volatility spread) – *_constant_* spread above the _Treasury_ spot curve such that *_PV cash flows = current price_* 3. **Option-adjusted spread** (OAS) – current spread over the benchmark yield *minus the portion attributable to the embedded options*

Question 45

Compare and Contract OAS and static spread durations

Answer 45

* OAS is like the static spread, but solved for stochastically so that the effect of embedded options is properly reflected. * Callable bond will only be called in down scenarios * Stochastic analysis could capture those scenarios, not just the current yield curve * OAS is less then static spread, reflecting the possible lost yield in future down scenarios * However, callable bonds still have higher yield spread than non-callable bonds of the same maturity, to compensate for call risk

Question 46

Portfolio spread duration

Answer 46

market weighted average of each bond’s spread duration

Question 47

Describe limitations of Classical single-period immunization assumptions

Answer 47

Assumptions: 1. I**nterest rates move in parallel** (most critical assumption) 2. **Fixed horizon date without any interim cash** flows before the horizon date 3. **Target value** = lower limit of the portfolio value at the horizon date if the *yield curve shape (structure) does not change* (i.e. no non-parallel shifts) most interest rate shifts are non-parallel, interim cash flows are common, and the term structure is likely to change before the horizon date

Question 48

Describe how classical immunization can be extended for **non-parallel interest rate shifts** of yield curve

Answer 48

* **Multi-functional** or functional duration – a.k.a. *key rate duration* * Immunize against **an arbitrary interest rate** change subject to the constraint that Portfolio Duration = Investment Horizon * Changes in portfolio value depend on: 1. *Structure* of investment portfolio 2. M2 = *immunization risk measure* (“maturity variance”)

Question 49

M² Immunization Risk Meausre for non-parallel interest rate shift

Answer 49

M2 = immunization risk measure (“maturity variance”) describes nature of interest rate shock: * If M2 is small, immunization risk is small

Question 50

Describe the steps under multiple liability immunization

Answer 50

1. Set asset portfolio duration = liability duration 2. Asset cash flows have higher dispersion than liability cash flows * must “bracket” liability cash flows * Distribution of individual asset durations is wider than the distribution of individual liability durations * Shortest asset \< shortest liability; longest liability \< longest asset

Question 51

Describe a problem with multiple liability immunization

Answer 51

Still exposed to non-parallel shifts

Question 52

Describe the issues that require immunizing general cash flows

Answer 52

* Previous immunization methods have assumed all **assets are invested at time zero** * There are often situations where some of the **assets won’t be available until a future date**

Question 53

Describe the steps for immunizing general cash flows

Answer 53

1. Assume future assets are a hypothetical investment maturing before liab horizon 2. Invest available funds to mature after liability horizon * Weighted avg duration (incl hypothetical assets) should match liability horizon 3. When the future assets become available: * Invest new funds in assets that will mature at the liability horizon * Sell existing longer assets and reinvest at the liability horizon

Question 54

Impact of Immunization for General Cash Flows on interest rate risk (non-parallel shifts)

Answer 54

* Any change in interest rates will have offsetting effects on each asset balance at the reinvestment date * E.g. interest rates fall, the longer assets will have a capital gain even though the new funds will be invested at a lower rate

Question 55

What is the goal of return maximization for immunized portfolios?

Answer 55

maximize the lower bound return given the investor’s risk tolerance * Expected Return +- 2 standard deviations (2 is an approx for 1.96 for 95% CI)

Question 56

Example of Expected Active porfolio return vs Expected Immunized return

Answer 56

* Suppose the **immunized return** available is 8% with 10 bps volatility: * Lower bound = 8.00% - 0.20% = 7.80% * But suppose an **active portfolio has an expected return** of 8.30% with 15 bps volatility * Lower bound = 8.30% - 0.30% = 8.00% * The *active portfolio’s return will exceed the expected immunized return **97.5%** of the time* * An investor may be comfortable with taking more liability funding risk to achieve a higher return

Question 57

When is contingent immunization possible?

Answer 57

* When the available immunized return (i) \> required rate of return to reach terminal value (“safety net rate of return,” s) * Cushion spread = max (0,i-s) * Pursue active management as long as there is a positive safety margin * Safety margin = current portfolio value - Min value required for Immunization * Thus, immunization is a fall-back strategy if the actively managed portfolio does not grow at a certain rate

Question 58

Initial minimum portfolio value required for (contingent) immunization

Answer 58

s and i are bond-equivalent (semiannual) yields above (but don’t have to be)

Question 59

Example of contigent immunization

Answer 59

For example, if a portfolio’s required rate of return is s = 3%, contingent immunization is possible as long as the portfolio can be immunized at a rate of return greater than 3% * This is because the portfolio value is worth more than the investment needed to mature the portfolio * The investment manager could then actively manage part of all of the portfolio If the actively managed portfolio’s value ever falls to the minimum required for immunization in the future, the portfolio should be immunized immediately (because the safety margin would be zero)

Question 60

Describe the sources of liability funding risk

Answer 60

1. **Interest rate risk** – reinvestment and disintermediation risk 2. **Contingent claim risk** (call and prepayment provisions) * Call/prepayment features add reinvestment risk 3. **Cap risk** (floating rate securities with caps) * If market rates rise above the cap, investor foregoes additional interest and bond behaves like a fixed bond

Question 61

Bullets vs. barbells (immunized portfolios)

Answer 61

* **Barbell portfolio** – made up of short and long maturities relative to the horizon date and interim coupon payments * **Bullet portfolio** – the bond maturities are very close to the investment horizon * Both strategies can be immunized against parallel interest rate shifts (both can be constructed to have the same duration) * **Barbells are more exposed to non-parallel shifts** * **Bullet strategies are less risky**

Question 62

Describe the differences between cash flow matching and multiple liability immunization.

Answer 62

* • Main problem with cash flow matching: * Exact matching is usually not possible * Reinvestment will be required = liability funding risk * Cash flow matching is **inferior** to multiple liability immunization because it requires: * Relatively high cash balance with a conservative rate of return * Funds available when or before each liability is due * Cash flow matching is still used sometimes because it is **easy!**

Question 63

Cash flow matching execution

Answer 63

Match the last liability cash flows first, and then work down to the first cash flow

Question 64

Describe the importance of reinvestment risk for immunization risk

Answer 64

Portfolios with the least reinvestment risk have the least immunization risk

Question 65

Describe the 2 extensions of basic cash flow matching

Answer 65

1. Symmetric cash flow matching 2. Combination matching (a.k.a. horizon matching)

Question 66

Symmetric cash flow matching

Answer 66

Ÿ Borrow short-term money to meet liability Ÿ Invest in longer assets that will mature after the liability

Question 67

Combination matching (a.k.a. horizon matching)

Answer 67

* Creates a duration-matched portfolio that is also cash flow matched in the first few years only (e.g. first 5 years) * Ensures short-term cash flows are met (e.g first 5 years) * Reduces risk of non-parallel shifts since most curvature is in short end of yield curve * Disadvantage: increases cost of funding liability

Question 68

List the considerations when applying dedication strategies.

Answer 68

1. Universe considerations (credit risk, embedded options, liquidity) 2. Optimization 3. Monitoring (periodic performance measurement) 4. Transaction costs (initial and rebalancing)

Question 69

Universe considerations when applying dedication strategies

Answer 69

``` Credit risk: using lower quality assets will increase the risk of default Embedded options (calls, prepayment options): complicates immunization and cash flow matching Liquidity: important for immunized portfolios, which require rebalancing ```

Question 70

Optimization considerations when applying dedication strategies

Answer 70

requires an iterative approach because there are many inputs/variations Immunized portfolios: minimize maturity variance while matching durations and having necessary dispersion Cash flow matching: minimize initial portfolio cost while ensuring sufficient cash for future liabilities Additional constraints: average quality, min/max concentrations, issuer constraints

Question 71

Monitoring considerations when applying dedication strategies

Answer 71

periodic performance measurement * Compare current target return with original * Compare current portfolio value with PV of remaining liabilities discounted at portfolio’s IRR * IRR = expected rate that allows portfolio to meet liabilities * Estimate standard deviation of terminal portfolio value: should approach zero as horizon date nears

Question 72

Describe 2 combination dedication strategies

Answer 72

* Active/passive combination * Large core passive portfolio with smaller actively managed portfolio * Active/immunization combination (e.g. contingent immunization)

Question 73

Define the portfolio rate of return formula, accounting for leveraging

Answer 73

Leverage creates more potential for higher returns but also more downside risk

Question 74

Define a repo agreement and repo interest rate

Answer 74

sell a security (e.g. T-bill) and agree to purchase it back (usually the next day) * Repo interest = Repurchase Price - Sale Price * Repo rate = effectively the borrowing rate, which is likely different than the T-bill’s rate * Higher repo rate -\> higher repurchase price for the seller (institution borrowing funds)

Question 75

Borrowing Cost of Repos

Answer 75

offers a low cost way to borrow short-term funds Ÿ Term to maturity is usually overnight or a few days Ÿ Can be extended by rolling over

Question 76

Methods of transferring Repo securities between parties

Answer 76

* Physical delivery (highest cost and usually not practical) * Credit and debit accounts with banks (cheaper but still has fees) * Deliver to custodial account at seller’s bank (reduces costs) * No delivery (OK of short term transactions if parties trust each other) * Lowest cost but default risk

Question 77

What are the factors that increase the repo rate?

Answer 77

1. Lower quality collateral (securities being exchanged) 2. Longer repo term (if upward sloping yield curve - common at short end) 3. No physical delivery (higher risk of default) 4. Collateral is in high supply or easy to obtain (less attractive for buyer/lender) 5. Higher prevailing interest rates in the economy 6. Seasonal factors that restrict supply or increase demand for repos

Question 78

Describe the non-duration risk measures and their disadvantages for fixed income.

Answer 78

* **Standard deviation (or variance)** – useful only if returns are normal * Most portfolio returns are not normal * The number of variances and covariances becomes very large as the number of bonds n increases: n \* (n + 1)/2 * Bond characteristics change over time * **Semivariance** – measures dispersion of returns below the target return * Not widely used: computationally challenging and unreliable for asymmetric returns * **Shortfall risk** * Does not account for the magnitude of losses * **• Value at risk (VaR)** – estimates the loss at a given percentile * Does not capture magnitude of losses beyond the specified percentile

Question 79

Major limitation of risk measure

Answer 79

universal and comprehensive risk measure does not exist

Question 80

List the products used in derivatives-enabled strategies

Answer 80

* Interest rate futures and forwards (bond futures) * Interest rate swaps (e.g. fixed for floating) * Interest rate options (calls and puts on physicals or futures, caps) * Credit risk instruments (forwards, spread options, swaps)

Question 81

Define interest rate futures and forwards

Answer 81

* Long party agrees to buy a bond from short party in the future at the futures price * Futures contract involving an underlying that pays interest (bond or other fixed income security)

Question 82

Delivery options with respect to Futures contracts

Answer 82

decisions that the seller can make at delivery * At delivery, the seller will deliver the cheapest-to-deliver (CTD) bond (a.k.a. *“quality option”* or “swap option”) * *May not be the same bond as the underlying*, which may not be available * **Conversion factor** – used to determine the *invoice price of each acceptable deliverable Treasury* * Timing option – seller can decide on the specific date within the delivery month * Wild card option – seller has until 8 PM Chicago time to give notice of intent to deliver

Question 83

Benefits of futures in managing portfolio duration

Answer 83

* liquid * fast * cost effective

Question 84

What is the formula to approximate the number of interest rate futures contracts to a target duration?

Answer 84

Question 85

Define basis risk

Answer 85

* Basis risk = risk of unpredictable changes in the basis * Basis = **Bond Cash** Price - **Futures** Price

Question 86

Define cross hedging

Answer 86

**hedged bond** is not the same as the **bond underlying the futures contract** * Increase basis risk * CTD option further complicates the process

Question 87

Define hedge ratio.

Answer 87

* Number of futures contracts needed for the hedge (similar to approx No. of futures contract formula) * The above hedge ratio assumes a fixed yield spread; to generalize for non-constant yield spreads, multiply the above hedge ratio by b (“yield beta”) from a regression analysis * Yield on Hedged Bond = a + b (Yield on CTD bond) + Error Term

Question 88

Minimizing cross hedging

Answer 88

requires choosing a hedge that minimizes volatility between the futures (based on the CTD bond) and the hedged bond (H)

Question 89

List the 3 major sources of hedging error

Answer 89

* Incorrect duration * Projected basis * Yield beta

Question 90

Define an interest rate swap and describe position of swap floating payer

Answer 90

Contract between two parties to exchange periodic interest payments based on a notional principal amount * Interest Payment = Specified Interest Rate \* Notional Amount For the floating payer, the swap is equivalent to owning portfolio with a *long fixed rate bond and a short floating rate bond*

Question 91

List the 3 ALM applications of swaps

Answer 91

* Alter asset and liability **cash flows** * Adjust the portfolio **duration** * **Cheaper/easier** alternative to using a package of **forward** contracts

Question 92

Define the dollar duration (DD) of an interest rate swap.

Answer 92

For floating payer: Swap DD = Fixed Rate Bond DD - Floating Rate Bond DD * =Fixed Rate Bond DD (since a floater’s duration is very small)

Question 93

Interest Rate Option Duration

Answer 93

a function of the underlying’s duration, option delta, and leverage (the 3rd term below)

Question 94

Signs of interest rate option duration

Answer 94

* Interest rate **call options have positive duration** (puts have negative duration) * **Calls have positive deltas**, while puts have negative deltas * Delta = change in option value given a change in the underlying’s price

Question 95

List 3 ways that hedging can be done with options

Answer 95

1. Buying protective puts – protects against rising interest rates 2. Selling covered calls – generates premium income on out-of-the-money calls 3. Interest rate caps, floors, and collars * Caps pay off if rates \> cap rate; floors pay off if rates \< floor rate * Collar = cap + floor

Question 96

Describe credit spread options

Answer 96

Payoff based on spread over a benchmark rate. Only pay off if ITM at maturity: * Payoff = max[(Spread at Option Maturity - K) \* Notional \* Risk Factor, 0] * Risk Factor = change in security value per 1 bps change in credit spread This is a put option. when the spread increases over a stike spread, the bond price decreases and the credit spread option pays off.

Question 97

Describe credit forwards

Answer 97

Credit forwards have similar payoffs to credit spread options, but no downside protection * Payoff = (Spread at Forward Maturity - K) \* Notional \* Risk Factor where K = “contracted credit spread” similar in concept to the strike spread

Question 98

Describe credit default swaps (CDS).

Answer 98

Shifts credit risk based on a reference entity from the protection buyer to the protection seller * Protection buyer pays regular swap premiums to the protection seller * If a defined credit event causes a loss on the reference entity bond, the protection seller pays the loss to the protection buyer

Question 99

List the advantages and uses of CDS

Answer 99

* Reduce credit risk concentration without selling or shorting assets * Hedge **non-publicly** traded debts * Protection seller does **not** have to make an **upfront investment** * Can be **tailored** to specific needs since over-the-counter

Question 100

State Ways the Active Manager can Add Value

Answer 100

1. Bond market selection 2. Currency selection 3. Duration management{yield curve management 4. Sector selection 5. Credit analysis of issuers 6. Investing in markets outside the benchmark

Question 101

Duration with Foreign Bonds

Answer 101

* The duration measure of a portfolio that includes domestic and foreign bonds must recognize the correlation between the movements in interest rates in the home country and each nondomestic market * Must adjust the duration formula because international yields are not perfectly correlated with domestic yields

Question 102

Thomas-Willner methodology for Duration of foreign bonds

Answer 102

Change in Foreign Bond Value = Duration \* Change in foreign yield given change in domestic yield \* 100

Question 103

Change in yield relationship for durations of foreign bonds

Answer 103

Question 104

Define currency risk

Answer 104

Risk associated with the uncertainty about the exchange rate at which proceeds in the foreign country can be converted into the investor’s home currency.

Question 105

When does a currency loss occur in international FI markets

Answer 105

A currency loss occurs when the **foreign currency depreciates** against the investor’s home currency

Question 106

Currency effect composition

Answer 106

* “**expected**” portion - captured by the **forward discount / forward premium** * “**unexpected**” portion - the unexpected movement of the foreign currency relative to its forward rate

Question 107

State how to compute the **forward discount/premium** based on the spot and forward exchange rates.

Answer 107

* f = (F-S₀) / S₀ * F is the forward exchange rate (stated as domestic currency/foreign currency) * S₀ is the spot exchange rate (stated as domestic currency/foreign currency) * f is the forward discount/premium (it is a premium if positive and a discount if negative)

Question 108

State the interest rate parity (IRP) equation.

Answer 108

* the forward foreign exchange rate discount or premium should equal the risk-free interest rate differential * f = id - i_f ( = approx) * Here, i_d is the domestic risk-free rate and i_f is the foreign risk-free rate

Question 109

State the three methods of currency hedging

Answer 109

1. Forward hedging 2. Proxy hedging 3. Cross hedging

Question 110

Currency Forward hedging

Answer 110

* Use forward contract between bond’s currency and home currency * Most popular approach

Question 111

Currency Proxy hedging

Answer 111

* Use forward contract between home currency and highly correlated currency with bond’s currency * Often used when forward markets in the bond’s currency are **relatively undeveloped**, or because it is otherwise **cheaper** to hedge using a proxy

Question 112

Currency Cross Hedging

Answer 112

* **Hedge two currencies other than the home currency** * Technique used to convert the currency risk of the bond into a different exposure that has less risk for the investor

Question 113

# Formula Currency Unhedged Return

Answer 113

approximately equals the foreign bond return in local currency (r_i) plus the currency return (e) R = r_i + e

Question 114

Currency Hedged Return

Answer 114

the sum of the foreign bond return in local currency (rl) **plus the forward discount (premium) f** HR = r_l + f = i_d + ( r_l - i_f )

Question 115

Breakeven Spread Analysis

Answer 115

* quantifies the amount of spread widening required to diminish a foreign yield advantage * The yield advantage of investing in a foreign country may disappear if either domestic yields increase or the foreign yield decline * Must ensure that the appropriate investment time horizon is used

Question 116

State Criteria for the Selection of a Fixed-Income Manager

Answer 116

1. Style analysis * A style analysis looks at how the portfolio differs from the benchmark 2. Selection bets * A manager that believes they have superior credit/security analysis skills may deviate weights based on credit or security analysis 3. The organization’s investment process * Need to understand the support staff and investment processes of the manager’s organization 4. Correlation of alphas * Plan sponsors will prefer low correlation among managers’ alpha to control/diversify portfolio risk

Question 117

State similarities between fixed-income and equity manager selection

Answer 117

1. Both frequently use a consultant to identify a universe of suitable manager candidates 2. Both realize past performance is not a reliable guide for future results 3. Qualitative factors are important for both 4. Management fees and expenses are important for both * Management fees may be even more important to monitor in the fixed-income area, because fixed-income funds tends to have a higher ratio of fees to expected outperformance