Flashcards in S10 Deck (67):

1

## Two negatives of using leverage in fixed income investing

###
- Negative impact on return if rate of return is smaller than cost of leverage

- Higher dispersion of portfolio returns

2

## Return formula using leverage

### Rportfolio = Rinvestment + B/E* (Rinvestment - CostofBorrowedFunds)

3

## Duration formula using leverage

### De = (Di*I - Db*B) / E

4

## Risks to REPO lender is collateral remains in borrowers custody

###
Borrower sells collateral

Goes bankrupt

Use collateral for a different loan

5

## Ways of reducing REPO risk

###
Physical delivery to lender

Depositing collateral in a custodial account at borrowers bank

Electronic security transfer

No action is borrower's credit risk is low or if transaction is short term

6

## REPO rate factors

###
Credit risk

Quality of collateral

Term of the repo

Collateral Delivery

Federal funds rate

Funds demand seasonality factors

7

## Drawbacks of standard deviation

###
- Bond returns are often not normally distributed

- The number of inputs increases with number of bonds in portfolio (N*(N+1)/2 assumptions needed)

- Historical calculations may not be applicable today

8

## Drawbacks of semivariance

###
- difficult to compute for large portfolios

- yields same results as standard deviation if returns are symmetric

- if returns are not symmetric, downside risk forecast is difficult to forecast

- uses just half of distribution so sample size is smaller - and less accurate statistically

9

## Criticism of shortfall risk

###
Ignores outliers, so magnitude of shortfall below target return is ignored

Not as commonly used as standard deviation

Statistical properties are not well known

Does not take form of $ amount (while VAR does)

10

## Criticism of VAR

### like Shortfall Risk, VAR ignores the magnitude of losses

11

## CTD Cheapest to Deliver price is =

### =Quoted futures price X conversion factor

12

## Advantages of using futures over cash market instruments

###
- more liquid

- less expensive

- easier to short vs actual bonds

13

## number of futures to be bought to alter DOLLAR duration to target

### nr = (DDt - DDp) / DDf

14

## number of futures to be bought to alter DOLLAR duration to target (using CTD)

### nr = (Dt-Dp) * Pp * CTDconversionFactor / (Dctd * Pctd)

15

## Price basis =

### = spot (cash) price - futures delivery price

16

## hedge ratio =

### = exposure of bond risk factor / exposure of futures to risk factor

17

## hedge ration of yield spread is not constant =

### DpPp * CTDconversionFactor * Yield Beta / (Dctd * Pctd)

18

## 3 sources of error in hedging

###
- forecast of basis at the time the hedge is lifted

- estimated durations

- estimated beta

19

## option delta measures the change in

### price of the option relative to the change in the underlying contract

20

## credit spread option value =

### max (actual spread - strike spread) x notional x risk factor, 0)

21

## six sources of excess return for an international bond portfolio

###
market selection (country),

currency selection,

duration management ,

sector selection ( = industries, ratings, maturity),

credit analysis ,

markets outside the benchmark

22

## foreign yield change (function of domestic yield change) =

### change in foreign yield = beta X change in local yield + contrantE

23

## contribution of foreign bond to total duration

### =Fweight in portfolio X Fduration X Fbeta

24

## Forward exchange rate (dom/for) =

###
Interest rate PARITY !!!

Spot exchange rate X (1 + domestic short term rate ) / (1 + foreign short term rate)

25

##
covered interest arbitrage

Covered interest differential exists if =

### (1 + dom rate) - (1+foreign rate) X (Forward exchange rate / Spot exchange rate)

26

## Proxy hedge

### Using 2nd foreign currency (with high correlation to 1st foreign) forwards to hedge FX risk

27

## Cross hedge

### Using a forward contract to deliver original foreign currency for a different foreign currency to hedge FX risk

28

## Foreign bond return =

### R = R of bond in local currency + R from currency change ( 1 + return from bond in local currency)

29

## foreign bond breakeven formula

###
(Foreign return - Domestic return ) / - (max of duration (foreign or local)

Discussion: yield on foreign should increase QWE over holding period for the decrease in price to wipe out yield advantage

30

## core plus fixed income approach

### holding core investment grade debt plus adding bonds perceived to have potential for generating added return.

31

## Advantages of investing in emerging market debt

###
Diversification benefit

Return enhancing

Increased quality in EM sovereign bonds

Increased resiliency

32

## Risks associated with investing in EM debt

###
Corporations do not have tools to offset negative events

EM debt returns are volatile and with negative skewedness

Higher credit risk due to lower transparency and weaker regulations

Under-developed legal system not protecting against adverse government action

Lack of standard covenant

Political risks

Lack of diversification in certain indexes

33

## Political risks in EM debt

###
Political instability

REGULATIONS: Changes in taxation and regulations

REGULATIONS: Relaxed regulations on bankruptcy

CURRENCY: Imposed changes in exchange rate (pegging)

CURRENCY: Potential currency conversion difficulties due to various Gov restrictions

34

## Criteria that should be utilized in determining the optimal mix of active managers

###
Style analysis,

Selection bets (credit spread analysis),

Investment processes (decision making, research process)

Alpha correlations.

35

## instruments for default risk hedging

###
credit options

credit swaps

36

## instruments for credit spread risk hedging

###
credit options

credit swaps

37

## instruments for downgrade risk hedging

###
credit options

credit swaps

38

## ALWAYS adjust the spread advantage to

### investment period as it is often less than one year in Schweser tests

39

## Credit spread forward contract - the payout is ignoring the

### time number of months until settlement.

40

## current forward exchange discount =

### = (Forwarx fx - spot fx) / spot fx

41

## impact on portfolio duration after increasing leverage by using 2yr REPO (compared to using overnight REPO)

### the longer the repo the larger NEGATIVE impact on levered portfolio duration

42

## leveraged portfolio duration formula denominator

### $ of equity (not total portfolio)

43

## hedged return for foreign bond =

###
domestic rfr + local risk premium =

domestic rfr + local Bond rate - local rfr

44

## contingent claim exists even if liabilities are funded from a portfolio with

### noncallable bonds.

45

## Hedging MBS with two contracts better

### matches the dispersion of MBS cash flows

46

## Spread Risk of MBS: Definition, when to hedge

###
- Risk that spread over corresponding Tbond will widen, thus lowering the value of MBS.

- Usually not hedged, but taken when spread is attractive (when likely to narrow)

47

## Interest rate risk of MBS: Definition, when to hedge

###
- Risk of interest rate increase to impact MBS value.

- might be selectively hedged via duration hedging

- non parallel changes in interest rate curve can be hedge with 2 bond hedge

48

## Prepayment risk of MBS: Definition, when to hedge

###
- is the cause of negative convexity (smaller benefit from lower interest)

- can be hedged via:

--- dynamic hedging (continuous futures trading)

--- options

49

## Volatility risk of MBS: Definition and when to hedge

###
- MBS can be evaluated as being composed of an option free bond and a short call option

- higher volatility increases value of call option and as a result causes a decline in MBS value

- if volatility is underestimated - buy options

- if volatility is overestimated - use dynamic hedging

50

## model risk of MBS: definition and when hedging needed

###
- risk of incorrectly estimating MBS cashflows

- cannot be hedged

51

## benefit/drawback from 2 bond MBS hedging

###
- better simulates the more evenly distributed and front loaded cash flows of MBS compared to one bond hedge

- doesn't address the negative convexity risk that arises from prepayment (could be hedged via options or dynamic hedging)

52

## assumptions of 2 bond hedge

###
- incorporates reasonable possible yield curve shifts

- used an adequate model for predicting prepayments given certain changes in yield

- includes reliable assumptions in the monte carlo simulations of interest rates

- knows the security's price change given a small change in yield

- knows that the average price change method yields good approximations.

53

## drawback of 2 bond hedging

###
- hedging is as good as the assumptions for the amount of rate change an curve reshapening

54

## steps in 2 bond hedging

###
- determine average absolute price change per 100$ for a given SHIFT in yield curve

- same for a given TWIST in yield curve

- solve system of equations for the required amounts of bond 1 and bond 2

55

## cuspy coupon MBS

###
- a MBS for which changes in interest rates have large effects on prepauments and hence on price

- given large negative convexity, adding calls and puts may be needed to better hedge in addition to 2 bond hedge

56

## MBS is more exposed to yield curve risk (changes in shape of the curve) compared to bonds because

### MBS cash flows are more evenly distributed (i.e. not bullets)

57

## MBS adjustable-rate are still exposed slightly to

### interest rate risk between reset periods.

58

## MBS backed by adjustable-rate mortgages, are subject to cap risk if

### underlying mortgage rates adjust upward to the point that they reach the cap

59

## Effective duration of a mortgage will drop precipitously when interest rates do

###
drop because the effective maturity of the bond decreases sharply as the

bond is more likely to be called

60

## A barbell strategy exploits

###
a flattening of the yield curve and

can immunize the duration of a portfolio just as a bullet bond portfolio could

61

## Due to negative convexity, MBS are considered to be

### market directional investments

62

## Yield of a MBS =

###
+ yield of equal interest rate risk Treasury

+ spread (= option cost + option adjusted spread)

63

## Assessing impact of a change in the yield curve on the price of MBS, using effective duration is inferior to using

### interest rate sensitivity, and this is why it is used in 2-bond hedge

64

## MBS investors usually want to capture value from changes in

###
mortgage spread (OAS) and not from changes in interest rates.

this is why risk related to changes in interest rate is being hedged using 2 bond hedge

65

## market directional feature of MBS can be removed by

### 2 bond hedging

66

## H2 and H10 determined for 2 bond hedge are multiplied to

### par amount (not market price) of relevant two bonds

67