R24 Yield Curve Strategies Flashcards
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Active strategies under assumption of a stable yield curve
- Buy and hold -Active decision to position the portfolio with longer duration and higher yield to maturity in order to generate higher returns than the benchmark. Note: Portfolio characteristics may diverge from benchmark.
- Roll down/ride the yield curve - This strategy requires an upward-sloping yield curve; the manager will buy a bond in anticipation of profiting from the price increase as the time to maturity shortens
- Sell convexity - portfolio manager could sell calls on bonds held in the portfolio, or he could sell puts on bonds he would be willing to own if, in fact, the put was exercised. Would earn additional returns in the form of option premiums. Owning MBS in a portfolio is loosely equivalent to writing options. Could also buy a callable bond.
- The carry trade -In a common carry trade, a portfolio manager borrows in the currency of a low interest rate country, converts the loan proceeds into the currency of a higher interest rate country, and invests in a higher-yielding security of that country.
Inter-market carry trades, those involving more than one currency are more varied and complex. First, the trade depends on more than one yield curve. Second, the investor must either accept or somehow hedge currency risk. Third, there may or may not be a duration mismatch.
Intra market carry trade - has interest rate risk
Inter market carry trade - has currency risk. Tend to have negative skew and fat tails. Assumes uncovered interest rate parity does not hold.
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Active strategies for yield curve movement of level, slope, and curvature
- Duration management - In its simplest form, duration management shortens portfolio duration in anticipation of rising interest rates (decreasing bond prices) and lengthens portfolio duration in anticipation of declining interest rates (increasing bond prices). Requires a manager to correctly anticipate changes in interest rates. A non-parallel shift will make this strategy less effective. Derivatives can be used to Alter Portfolio Duration
- Buy convexity. To mitigate price declines and enhance price increases. Short a callable bond. Buy options.
- Bullet and barbell structures
- Bullett is used to take advantage of a steepening yield curve—a bulleted portfolio will have little or no exposure at maturities longer or shorter than the targeted segment of the curve.
- Barbell is typically used to take advantage of a flattening yield curve. If long rates fall more than short rates (and the yield curve flattens), the portfolio’s long-duration securities will capture the benefits of the falling rates in a way that the intermediate-duration securities cannot. are typically used to take advantage of a flattening yield curve.
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Relative Performance of Bullets and Barbells under Different Yield Curve Scenarios
Yield Curve Scenario Barbell Bullet
Level change Parallel shift Outperforms Underperforms
Slope change Flattening Outperforms Underperforms
Steepening Underperforms Outperforms
Curvature Less curvature Underperforms Outperforms
More curvature Outperforms Underperforms
Rate volatility change Decreased Underperforms Outperforms
Increased Outperforms Underperforms
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Carry Trade Intra Market
There are at least three basic ways to implement a carry trade to exploit a stable, upward-sloping yield curve:
- Buy a bond and finance it in the repo market.
- Received fixed and pay floating on an interest rate swap.
- Take a long position in a bond (or note) futures contract.
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Carry Trade Inter Market
- Borrow in low rate currency, convert into a high rate currency and buy a bond denominated in this currency.
- Currency Swap - recieve payments in the high rate currency and make payments in the low rate currency.
- Borrow in high rate currency and use proceeds to buy a bond denominated in this currency. Use FX forward to convert financing position into low rate currency (buy high rate currency forward).
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Butterfly
- Combination of a barbell and bullett
- A curve trade.
- If curvature increase go long the wings (barbell and short the body (bullet). Long Butterfly
- If curvature decreases then go short butterfly
- Butterfly spread:
2 x medium yield - short term yield - long term yield
- Whether the body goes up or down indicates the direction of the curvature - increase or decrease
- Duration neutral
- Long butterfly has higher convexity and benefits from a rise in interest rate volatility
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Predicted market value change
Predicted market value change = [Portfolio par amount × (−Key rate PVBP) × Curve shift]/100.
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Benchmark Spread
The benchmark spread is a simple way to calculate a credit spread; it subtracts the yield on a recently issued benchmark-sized security with little or no credit risk (benchmark bond) of a particular maturity from the yield on a credit security. Typically, the benchmark bond is an on-the-run government bond. A problem with benchmark spread is the potential maturity mismatch between the credit security and the benchmark bond. Unless the benchmark yield curve is perfectly flat, using different benchmark bonds will produce different measures of credit spread.
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I Spread
The I-spread normally uses swap rates that are denominated in the same currency as the credit security.
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G Spread
The G-spread is the spread over an actual or interpolated government bond.
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Credit Relative Value Analysis
In the case of unchanged spreads, credit relative value analysis is essentially about weighing the unknown prospect of default losses or credit rating migration against the known compensation provided by credit spreads.
Excess return can be calculated as:
EXR ≈ (s)(t) – (Δs)(SD) – (t)(p)(L),
where EXR = Excess return, s = Spread, t = Holding period, Δs = Change in spread, SD = Spread duration, p = Expected probability of default, and L = Expected loss severity.
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The number of futures contracts needed to fully remove the duration gap
The number of futures contracts needed to fully remove the duration gap between the asset and liability portfolios is given by:
Nf = (BPVL − BPVA)/BPVf
where BPV is basis point value (of the liability portfolio, asset portfolio, and futures contract, respectively).
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Number of futures to close duration gap
The number of futures contracts needed to fully remove the duration gap between the asset and liability portfolios is given by:
Nf = BPVL−BPVA / BPVf, where BPV is basis point value (of the liability portfolio, asset portfolio, and futures contract, respectively)
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What is Credit Quality of Value Weighted Index
Compared with other weighting schemes, such as equally weighted, value-weighted indexes are tilted toward issuers with higher levels of debt. The more an issuer or sector borrows, the greater the tilt toward that issuer in the index. Leverage and creditworthiness are negatively correlated, so a value-weighted index will be more susceptible to credit quality deterioration than an equally weighted index will be
