Fixed Income LIII Practice Test (Answered) Verified Solution

Fixed Income LIII Practice Test (Answered) Verified Solution Expected Excess Return (s x t) - (changeins x SD) - (t x p x l) Interpolated Yields 1) Your Bond Interest Rate = (Wi x Duration Bond A) + ((1 - Wi) x Duration Bond B) 2) (w)(int. rate) + (1-w)(int. rate) 3) Your Bond Int. Rate - weighted average interest rate Empirical Duration Duration determined by regression analysis of the historical relationship between security prices and yields Investment-Grade - Default-Risk and Credit Spread Lower and narrower compared to IG Narrowing of Spreads During Market Expansion Narrow more for HY relative to IG, meaning outperformance in rising rate environment (lower empirical duration) Carry Trade Executed by selling bonds with low yields and investing in bonds with high yields thereby earning a yield advantage when positions are carried over the investment period Carry Trade - YC Steepness Base your carry trade off of the STEEPER YC Intermarket Carry Trade - Duration Neutral The carry trade will have positive duration and will need to be hedged by SELLING long-dated bonds in the OPPOSITE market and BUYING ST Bonds in that market (i.e., if your carry trade is in US, carry out the neutral duration in the other state) Intermarket Carry Trade - Cash Neutral Buy the same market value in one market that is sold in the other - If cash neutral, NO NEED to hedge currency exposure Expected Return - Formula Income Yield + Rolldown Return + Change in price due to changes in yield and credit spread +/- credit g/l +/- Currency g/l Rolling Yield - Formula Income Yield + Rolldown Return Income Yield - Formula Annual Coupon / Current Bond PORT Price Rolldown Return - Formula (Bond price end of horizon period - Bond price beginning of horizon period) / (bond price beginning of horizon period) Roll-Down Return - Assumption Based on projected price change if YC DOES NOT CHANGE Changes in Yield and Credit Spread - Formula (-SD x Change in spread) + (.5 x convexity x change in spread^2) Leveraged Return - Formula Rl + (Vb / Ve)(Rl -Rb) Increase Duration With Swap Receive Fixed, Pay Floating - Borrowing sort rates to invest at longer rates Futures on Fixed Income Securities Leverage, taking long positions in FI futures allows for upside of buying that notional amount of bonds with small initial outlay to post margin Repos - Leverage Way to borrow the funds necessary to leverage a PORT - Substance of transaction is borrowing funds using securities as collateral for loan Fixed Income - 3 Characteristics - Predictable cash flows can be used to meet recurring payout needs - Diversification due to low correlation with equities - Inflation hedging low unless have floating rate not bonds FI Correlation to Equity in Downturns Even MORE NEGATIVE during downturns - Investors flee to high-quality government bonds, driving up prices and driving down yields Floating-Rate Bonds - Inflation Coupon payments increase with increasing inflation Multiple Liabilities Immunization - 2 Things Needed - MATCH BPV of PORT and Time Horizon - ASSET convexity somewhat higher than liabilities to hedge against CURVE RESHAPING Can Structural Risk be Completely Removed from PORT? YES, a zero-coupon bond would provide perfect immunization with no structural risk for a single liability if the maturity of the zero-coupon bond is set to the date of the liability Cash-Flow Matching Strategy - Investment Universe LIMITS asset selection to only those with cash flows matching liability dates - LEAST FLEXIBLE in bond selection Cash-Flow Matching - Return Generally locks in LOWEST RETURN Enhanced Indexing Fewer securities than the index but matches the primary risk factors present in the index Value-Weighted Index - FI Assigns larger share of the index to issuers with larger amounts of outstanding debt - Investors tracking the index have more exposure to those highly levered borrowers - BUMS PROBLEM - negative correlation between issuer's credit worthiness and leverage Immunization - Matching... Asset and liability MacDur or BPV Cash-Flow Yield vs YTM - Upward Sloping YC Cash-flow yield (IRR) reflects more weight on LONGER MATURITY BONDS - Higher yield of longer maturity bonds will pull the PORT IRR above the more traditional average YTM Contingent Immunization - If Surplus Turning Negative... PORT must be immunized to stabilize the surplus Target-Date ETFs Can Be Used... As an alternative to a bond maturing on the ETF's target date - The ETF is managed to come due on that date Selling Options - Duration/Convexity NEGATIVE Benefits For Convexity Only Occur For (Changes in Interest Rates) LARGE changes in interest rates Reduce Convexity if... Actual volatility is BELOW initial consensus expectations - Think of it as selling options when the prices are very high Intramarket Carry Trade - YC Requires only one YC Do You Hedge Currency Risk in Inter-market Carry Trade? NO, negates any interest rate differential that the carry trade is attempting to exploit Pay Fixed Swap Reduces... PORT Duration Buying MBS - Convexity REDUCES convexity Butterfly Trade Long Barbell short bullet - If the U.S. Treasury curve increases in curvature at the 12-year maturity, a short position in the intermediate maturity (12-year) and long positions in the barbells (7-year and 17-year) will produce a profit Increase in Interest Rate Volatility Impact on MBS DECREASES the price of MBS - If volatility increases, this increases the value of the prepayment option CDO - Diversification from Corporate Bonds? NO, underlying collateral for CDOs are corporate bonds FI - Solution to Lack of Liquidity - Use of ETF's as temporary investment - Hold larger percentage of PORT in cash - Hold larger percentage of PORT in liquid securities, even if falling outside of objectives - Use liquid derivatives