Session 7 - Fixed Income (I) Flashcards

Question

Repurchase Agreements

Answer 1

- a sale & a repurchase (basically a collateralized loan) - difference between the sale & repurchase price called the repo rate (= interest) - typically overnight → few days (maybe longer) - repo may be: -- cash-driven – borrow cash to buy assets -- security-driven – borrow particular securities - protection against default provided by collateral high quality → 97% - 99% borrowing capacity – called the ‘haircut’ - lower quality/higher volatility → lower capacity

Answer 2

– like repos, except that cash is required as collateral (or high-quality bonds) - when bonds are used as collateral, income earned flows back to borrower Rebate rate = coupon – lending rate – if the borrowed securities are difficult to borrow, the lending rate may be greater than the coupon income of collateral - typically open-ended agreements

Answer 3

– magnified losses, higher risk, forced liquidations

Answer 4

(𝑫𝑨𝑨 − 𝑫𝑳𝑳) / E

Answer 5

Type 2 - Cash Flow is known, timing not known (life insurance payout) Type 3 - Cash Flow unknown, timing is known (floating rate annuity payout)

Answer 6

- construct a portfolio that minimizes the variance in the realized rate of return - matching a future liability with an equal term zero-coupon bond settles it (no risk ~ cash flow matching) - if we must deal with bonds with incoming cash flows, we have price and Re-investment Risk exposure 1. set duration of portfolio = investment horizon (minimum condition) (or Liability duration) 2. initial PV of portfolio CFs ≥ PV of future liability 3. Portfolio Convexity is minimized

Answer 7

- price risk & reinvestment risk are offset which is achieved through mgmt. of duration - immunization is essentially an interest rate hedging strategy - market yield will fluctuate over the investment horizon - portfolio duration will change as both market yields change and time passes - as time passes, the portfolio must be rebalanced so that its duration (not avg) is readjusted to the duration of the liability - essentially a ‘zero-replication’ strategy i. e. immunizing with coupon paying bonds entails continuously matching the portfolio MacDur with the MacDur of a zero over time as the yield curve shifts

Answer 8

- no risk immunization strategy - Zero variance in ROR - variance results from the volatility of future interest rates

Answer 9

– portfolio CFs concentrated around the horizon date - low variance in ROR - variance results from the volatility of future interest rates

Answer 10

– portfolio’s CFs dispersed - High variance in ROR - variance results from the volatility of future interest rates

Answer 11

– risk that yield curve twists and non-parallel shifts cause MacDurp ≠ MacDurz (or L) - reduced by minimizing the dispersion of the bond positions - min. dispersion is the same as min. Convexity

Answer 12

- can improve the company’s credit rating (dedicated assets reduce liability risk) - may be able to use ‘accounting defeasance’ – ability to remove both the asset & liability from the B.S. - cash-in-advance constraint ⇒ bonds are not sold to meet obligations, they mature ⇒ maturity timing mismatches mean funds must be available before each liability pmt. - may lead to large cash holdings

Answer 13

1) PVassets ≥ PVliabilities 2) Dollar Duration of portfolio = DDL 3) distribution of individual portfolio assets must have a wider range than the distribution of the liabilities (higher dispersion, ∴ higher convexity) i.e. must have an asset with ModDur ≤ shortest-duration liability & an asset with ModDur ≥ longest-duration liability but: wider the range, more reinvestment risk - DDp will drift from DDL – twists & non-parallel shifts in the yield curve - must balance transaction costs against duration drift

Answer 14

higher gains if yields fall, lower losses if yields rise

Answer 15

- long an interest rate futures contract increases a portfolio’s sensitivity to interest rates (increase duration) - short → decreases sensitivity (decrease duration) - traded on both short-term (T-Bills, Eurodollars) and long-term (Treasury Notes, Bonds) - duration of the futures contract is the duration of the CTD

Answer 16

→ the seller determines which actual bond to deliver

Answer 17

- based on the price a deliverable bond would sell for at the beginning of the delivery month if it were to yield 6%

Answer 18

𝑵𝒇 = 𝑩𝑷𝑽𝑳 − 𝑩𝑷𝑽𝑨/ 𝑩𝑷𝑽𝑭 𝑩𝑷𝑽𝑨 + 𝑵𝒇𝑩𝑷𝑽𝑭 = 𝑩𝑷𝑽𝑳 𝑩𝑷𝑽𝑳 = 𝑫𝑫𝑳 ×. 𝟎𝟎𝟎𝟏

Answer 19

𝑩𝑷𝑽𝑪𝑻𝑫/𝑪𝑭𝑪𝑻𝑫 | ≈ (𝑫𝑪𝑻𝑫𝑽𝑪𝑻𝑫 ×. 𝟎𝟎𝟎𝟏) / 𝑪𝑭𝑪𝑻𝑫

Answer 20

1. pay floating, receive fixed ~ long a fixed + short a - adding a swap (pay fl., rec. fx.) increases BPVA ~ BPVfix 𝑩𝑷𝑽𝒔𝒘𝒂𝒑 = 𝑩𝑷𝑽𝒇𝒊𝒙 − 𝑩𝑷𝑽𝒇𝒍𝒐𝒂𝒕 − 𝑩𝑷𝑽𝒇𝒊𝒙 mainly determines 𝑩𝑷𝑽𝒔𝒘𝒂𝒑 since 𝑩𝑷𝑽𝒇𝒍𝒐𝒂𝒕 is typically small 2. pay fixed, receive floating ~ long a floating + short a fixed - adding a swap (pay fx., rec. fl.) decreases BPVA ~ BPVfix 𝑩𝑷𝑽𝒔𝒘𝒂𝒑 = 𝑩𝑷𝑽𝒇𝒍𝒐𝒂𝒕 − 𝑩𝑷𝑽𝒇𝒊𝒙

Answer 21

a) receiver swaption pay fl.rate, receive fixed - pay premium (known cost) -exercise if fixed swap rate is below exercise rate b) payer swaption– pay fx. - receive fl. - receive a premium ( not known) - when the receiver and payer combined = swaption collar

Answer 22

- receive fixed, enter the receiver swaption - increase duration - buy future contracts - long interest rate options - if BPVA > BPVL – do nothing

Answer 23

- pay fixed, enter the payer swaption - decrease duration - short future contracts - short interest rate options - if BPVA < BPVL – do nothing

Answer 24

– the extent of interest rate risk management - 0% – no hedging 100% – full hedging - partial hedge – between 0% - 100% 𝑩𝑷𝑽𝑨 × 𝚫𝒚𝒊𝒆𝒍𝒅𝒔𝑨 + 𝑩𝑷𝑽𝑯 × 𝚫𝒚𝒊𝒆𝒍𝒅𝒔𝑯 ≈ 𝑩𝑷𝑽𝑳 × 𝚫𝒚𝒊𝒆𝒍𝒅𝒔𝑳

Answer 25

– whenever assumptions are made about future events & approximations are used to measure key parameters (BPVA, BPVL)

Answer 26

– approximating portfolio duration using the weighted average of the individual durations of the component bonds instead of the cash flow yield (BPVA) - also, BPVH ⇒ an approximation is used (𝑩𝑷𝑽𝑪𝑻𝑫/𝑪𝑭)

Answer 27

- source of risk if assets, derivatives and liabilities are positioned at varying points along the curve and at varying spreads (𝜟yield for A & L refer to various classes of corporate bonds) L = IG, A may have HY

Answer 28

– underlying of BPVH are Treasuries, BPVL are typically corporate obligations (𝝆HL < 1) (IG corporate yields less volatile than Treasuries) - less volatility in the corporate/swap spread than the corporate/Treasury spread

Answer 29

when not collateralized

Answer 30

– the risk that available collateral becomes exhausted

Answer 31

- no specific rate of return (ROR) is guaranteed - objective: relative performance (match/exceed ROR of the benchmark) - known as investing on a benchmark relative basis • lower fees, greater diversification, avoiding the downside risk of active mgmt.

Answer 32

1) fixed income markets are much larger & broader - # of outstanding securities much larger - much more heterogeneous 2) fixed income is a dealer market - most bonds have a less active secondary market - many do not trade on a given day - stale prices or prices that are estimated using matrix pricing (creates variation between portfolios and the index) 3) limited size of many issues – often completely owned by buy-and-hold investors 4) index composition tends to change frequently – maturities, callability, new issues - typically recreated monthly ⇒ as composition changes, risk profiles may change

Answer 33

1/ portfolio modified adjusted duration – EffDur. - option-adjusted duration, convexity 2/ key rate duration - captures the effect of shifts at key points on the yield curve - matching key rate Dur. instead of only EffDur. will reduce tracking risk 3/ sector and quality percent - match the %’ age weight in the various sectors & qualities of the index (further away, greater the tracking risk) 4/ sector and quality spread duration - match the sector & quality duration exposure 5/ sector/coupon/maturity cell weights – match the optionality exposure of sectors 6/ issuer exposure – match the issuer-event risk

Answer 34

- assumes bond market expectations are correct, so set the portfolio’s risk profile identical to the benchmark index’s risk profile

Answer 35

``` 1/ pure bond indexing (full replication) 2/ enhanced indexing (sampling) 3/ fixed-income mutual funds 4/ ETFs - greater liquidity vs. MF 5/ Total return swap (OTC) - exchange of CFs between 2 parties ```

Answer 36

- produce a portfolio that is a perfect match to the index (own all the bonds in the same %’age as the index) - very difficult & costly (many issues are illiquid/infrequently traded, esp. non-Treasuries) - full replication rarely attempted in fixed-income

Answer 37

– attempt to match the Primary risk factors and reach a higher return versus full replication - done by stratified sampling - reduces construction & maintenance costs - larger tracking error vs. full replication

Answer 38

``` 1/ lower cost enhancements 2/ issue selection enhancements 3/ yield curve enhancements 4/ sector/quality enhancements 5/ call exposure enhancements ```

Answer 39

- lower investment requirement without sacrificing diversification - redemption at NAV rather than a need to sell positions

Answer 40

- smaller initial outlay - lower swap bid-ask spreads - total return receiver pays LIBOR + spread and depreciation of the index - total return payer pays Index CFs+ Appreciation

Answer 41

1) Unambiguous – the identities & weights of the benchmark components are clearly defined (clear, transparent rules for security inclusion and weighting) 2) Investable 3) Measurable – benchmark returns are readily calculable on a reasonably frequent basis - bond index risk characteristics will reflect bond issuers preferences - cap-weighted bond indices give more weight to issuers that borrow the most (the bums) - maybe more likely to be downgraded in the future and experience lower returns

Answer 42

- better protection from shifts/twists in the yield curve - cash flows diversified across time - balances cash flow reinvestment & market price risk - similar to dollar-cost averaging - bonds mature each year and are reinvested at the longer end of the ladder (portfolio duration is constant) - liquidity – always a bond that is close to redemption – low duration, stable price

Answer 43

- tight controls on trading costs and management fees (limit # of securities chosen)

Answer 44

- identify & select undervalued securities, select ‘possible credit upgrade’ issues, avoid ‘possible credit downgrade’ issues

Answer 45

- overweight the undervalued areas of the curve, underweight the overvalued areas

Answer 46

- periodic over/underweighting of sectors/qualities across the business cycle e. g. overweight Treasuries when spreads are expected to widen

Answer 47

- underweight callable bonds if rates are expected to drop e. g./ a drop in rates may cause a callable bond to shift from being priced on a YTM basis to a yield-to-call basis (negative convexity)

Session 7 - Fixed Income (I) Flashcards

(71 cards)