Managing Bond Portfolios: Investments
Managing Bond Portfolios: Investments
Managing Bond Portfolios: Investments
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Copyright
2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Duration
A measure of the effective maturity of
a bond
The weighted average of the times
until each payment is received, with
the weights proportional to the present
value of the payment
Duration is shorter than maturity for all
bonds except zero coupon bonds.
Duration is equal to maturity for zero
coupon bonds.
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Duration: Calculation
wt CF t (1 y ) Price
T
D t wt
t 1
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Duration/Price Relationship
Price change is proportional to duration
and not to maturity
(1 y )
P
Dx
P
1 y
D* = modified duration
P
D * y
P
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D y
*
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Zero
The zero-coupon
bond initially sells for
$1,000/1.05 3.7704 =
$831.9704.
At the higher yield, it
sells for
$1,000/1.053.7704 =
$831.6717. This price
also falls by 0.0359%.
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Convexity
The relationship between bond prices
and yields is not linear.
Duration rule is a good approximation
for only small changes in bond yields.
Bonds with greater convexity have
more curvature in the price-yield
relationship.
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Figure 16.3 Bond Price Convexity: 30Year Maturity, 8% Coupon; Initial YTM
= 8%
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Convexity
1
Convexity
2
P (1 y )
CFt
2
(1 y ) t (t t )
t 1
P
2
1
D y [Convexity (y ) ]
2
P
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Callable Bonds
As rates fall, there is a ceiling on the
bonds market price, which cannot rise
above the call price.
Negative convexity
Use effective duration:
P / P
Effective Duration =
r
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Mortgage-Backed Securities
The number of outstanding callable
corporate bonds has declined, but the
MBS market has grown rapidly.
MBS are based on a portfolio of
callable amortizing loans.
Homeowners have the right to repay
their loans at any time.
MBS have negative convexity.
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Mortgage-Backed Securities
Often sell for more than their principal
balance.
Homeowners do not refinance as soon as
rates drop, so implicit call price is not a
firm ceiling on MBS value.
Tranches the underlying mortgage pool
is divided into a set of derivative securities
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Passive Management
Two passive bond portfolio strategies:
1.Indexing
2.Immunization
Both strategies see market prices as
being correct, but the strategies have
very different risks.
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Immunization
Immunization is a way to control interest
rate risk.
Widely used by pension funds, insurance
companies, and banks.
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Immunization
Immunize a portfolio by matching the
interest rate exposure of assets and
liabilities.
This means: Match the duration of the assets
and liabilities.
Price risk and reinvestment rate risk exactly
cancel out.
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Active Management:
Swapping Strategies
Substitution swap
Intermarket swap
Rate anticipation swap
Pure yield pickup
Tax swap
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Horizon Analysis
Select a particular holding period and
predict the yield curve at end of period.
Given a bonds time to maturity at the
end of the holding period,
its yield can be read from the
predicted yield curve and the end-ofperiod price can be calculated.