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Chapter 11. Managing Bond Portfolios. Interest Rate Sensitivity (Duration we will cover in Finc420). The concept: Any security that gives an investor more money back sooner (as a % of your investment) will have lower price volatility when interest rates change.

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Presentation Transcript
chapter 11

Chapter 11

Managing Bond Portfolios

interest rate sensitivity duration we will cover in finc420
Interest Rate Sensitivity(Duration we will cover in Finc420)

The concept:

  • Any security that gives an investor more money back sooner (as a % of your investment) will have lower price volatility when interest rates change.
  • Maturity is a major determinant of bond price sensitivity to interest rate changes, but
  • It is not the only factor; in particular the coupon rate and the current ytm are also major determinants.

11-2

more on duration
More on Duration
  • Duration increases with maturity
  • A higher coupon results in a lower duration
  • Duration is shorter than maturity for all bonds except zero coupon bonds
  • Duration is equal to maturity for zero coupon bonds
  • All else equal, duration is shorter at higher interest rates

11-3

duration price relationship
Duration/Price Relationship

D = Duration

Price change is proportional to duration and not to maturity

DP/P = -D x [Dy / (1+y)]

D* = modified duration

D*= D / (1+y)

DP/P = - D* x Dy

11-4

interest rate risk
Interest Rate Risk

Interest rate risk is the possibility that an investor does not earn the promised ytm because of interest rate changes.

A bond investor faces two types of interest rate risk:

  • Price risk: The risk that an investor cannot sell the bond for as much as anticipated. An increase in interest rates reduces the sale price.
  • Reinvestment risk: The risk that the investor will not be able to reinvest the coupons at the promised yield rate. A decrease in interest rates reduces the future value of the reinvested coupons.

The two types of risk are potentially offsetting.

11-5

immunization
Immunization
  • Immunization: An investment strategy designed to ensure the investor earns the promised ytm.
  • A form of passive management, two versions
    • Target date immunization
      • Attempt to earn the promised yield on the bond over the investment horizon.
      • Accomplished by matching duration of the bond to the investment horizon

11-6

immunization1
Immunization
  • Net worth immunization
  • The equity of an institution can be immunized by matching the duration of the assets to the duration of the liabilities.

11-7

cash flow matching and dedication
Cash Flow Matching and Dedication
    • Cash flow from the bond and the obligation exactly offset each other
    • Automatically immunizes a portfolio from interest rate movements
  • Not widely pursued, too limiting in terms of choice of bonds
  • May not be feasible due to lack of availability of investments needed

11-8

problems with immunization
Problems with Immunization
  • May be a suboptimal strategy
  • Does not work as well for complex portfolios with option components, nor for large interest rate changes
  • Requires rebalancing of the portfolio periodically, which then incurs transaction costs
    • Rebalancing is required when interest rates move
    • Rebalancing is required over time

11-9

the need for convexity calculation in finc 420
The Need for Convexity(calculation in Finc 420)
  • Duration is only an approximation
  • Duration asserts that the percentage price change is linearly related to the change in the bond’s yield
    • Underestimates the increase in bond prices when yield falls
    • Overestimates the decline in price when the yield rises

11-10

convexity definition and usage
Convexity: Definition and Usage

Where: CFt is the cash flow (interest and/or principal) at time t and y = ytm

The prediction model including convexity is:

11-11

swapping strategies active
Swapping Strategies - active
  • Substitution swap
    • Exchanging one bond for another with very similar characteristics but more attractively priced
  • Intermarket spread swap
    • Exploiting deviations in spreads between two market segments
  • Rate anticipation swap
    • Choosing a duration different than your investment horizon to exploit a rate change.
      • Rate increase: Choose D > Investment horizon
      • Rate decrease: Choose D < Investment horizon

11-12

swapping strategies
Swapping Strategies
  • Pure yield pickup
    • Switching to a higher yielding bond, may be longer maturity if the term structure is upward sloping or may be lower default rating.
  • Tax swap
    • Swapping bonds for tax purposes, for example selling a bond that has dropped in price to realize a capital loss that may be used to offset a capital gain in another security

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