1 / 108

Fixed Income 2

Fixed Income 2. Zvi Wiener. Plan FI-2. Example of Duration and Convexity Treasuries Agencies Corporate Municipals The Treasury Securities Markets: Overview and Recent Developments, by D. Dupont and B. Sack, Federal Reserve Bulletin, Dec-99. Example.

letitia
Download Presentation

Fixed Income 2

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Fixed Income 2 Zvi Wiener

  2. Plan FI-2 • Example of Duration and Convexity • Treasuries • Agencies • Corporate • Municipals The Treasury Securities Markets: Overview and Recent Developments, by D. Dupont and B. Sack, Federal Reserve Bulletin, Dec-99. FI-2

  3. Example Portfolio consists of $1M of a bond with duration of 1 year and $1M worth of a bond with duration of 20 years. What is the duration of the portfolio? FI-2

  4. Rough calculation Duration of the first bond is 1 year, of the second bond is 20 years. This means that when IR go 1% up we will lose 1% of the first bond and 20% of the second. All together we will lose 10.5% of the portfolio. The duration is (roughly) 10.5 years. FI-2

  5. Value value Parallel shift FI-2

  6. Duration FI-2

  7. Convexity For a simple bond portfolio it does not help much! It is much more important to consider 2 risk factors! FI-2

  8. Portfolio 2 Time 0 1 5 20 value Money +1 -2 +2 Term Structure 5% 6% 7% Assets duration = 7.19 Liabilities duration = 4.7169 FI-2

  9. Zero Coupon Bond 8% Coupon Bond FI-2

  10. Macaulay Duration FI-2

  11. Understanding of Duration/Convexity What happens with duration when a coupon is paid? How does convexity of a callable bond depend on interest rate? How does convexity of a puttable bond depend on interest rate? FI-2

  12. Callable bond The buyer of a callable bond has written an option to the issuer to call the bond back. Rationally this should be done when … Interest rate fall and the debt issuer can refinance at a lower rate. FI-2

  13. Puttable bond The buyer of a such a bond can request the loan to be returned. The rational strategy is to exercise this option when interest rates are high enough to provide an interesting alternative. FI-2

  14. regular bond strike callable bond Imbedded Call Option r FI-2

  15. putable bond Imbedded Put Option regular bond r FI-2

  16. Stock Convertible Bond Straight Bond Convertible Bond Payoff Stock FI-2

  17. Timing of exercise • European • American • Bermudian • Lock up time FI-2

  18. Passive Bond Management Passive management takes bond prices as fairly set and seeks to control only the risk of the fixed-income portfolio. • Indexing strategy • attempts to replicate a bond index • Immunization • used to tailor the risk to specific needs (insurance companies, pension funds) FI-2

  19. Bond-Index Funds Similar to stock indexing. Major indices: Lehman Brothers, Merill Lynch, Salomon Brothers. Include: government, corporate, mortgage-backed, Yankee bonds (dollar denominated, SEC registered bonds of foreign issuers, sold in the US). FI-2

  20. Bond-Index Funds Properties: many issues not all are liquid replacement of maturing issues Tracking error is a good measurement of performance. According to Salomon Bros. With $100M one can track the index within 4bp. tracking error per month. FI-2

  21. Cellular approach FI-2

  22. Immunization Immunization techniques refer to strategies used by investors to shield their overall financial status from exposure to interest rate fluctuations. FI-2

  23. Net Worth Immunization Banks and thrifts have a natural mismatch between assets and liabilities. Liabilities are primarily short-term deposits (low duration), assets are typically loans or mortgages (higher duration). When will banks lose money, when IR increase or decline? FI-2

  24. Gap Management ARM are used to reduce duration of bank portfolios. Other derivative securities can be used. Capital requirement on duration (exposure). Basic idea: to match duration of assets and liabilities. FI-2

  25. Target Date Immunization Important for pension funds and insurances. Price risk and reinvestment risk. What is the correlation between them? FI-2

  26. Target Date Immunization Accumulated value Original plan 0 t* t FI-2

  27. Target Date Immunization Accumulated value IR increased at t* 0 t* t FI-2

  28. Target Date Immunization Accumulated value 0 t* D t FI-2

  29. Target Date Immunization Accumulated value Continuous rebalancing can keep the terminal value unchanged 0 t* D t FI-2

  30. Good Versus Bad Immunization value $10,000 Single payment obligation 0 8% r FI-2

  31. Good Versus Bad Immunization value Good immunizing strategy $10,000 Single payment obligation 0 8% r FI-2

  32. Good Versus Bad Immunization value Good immunizing strategy $10,000 Single payment obligation 0 8% r FI-2

  33. Good Versus Bad Immunization Bad immunizing strategy value Good immunizing strategy $10,000 Single payment obligation 0 8% r FI-2

  34. Standard Immunization Is very useful but is based on the assumption of the flat term structure. Often a higher order immunization is used (convexity, etc.). Another reason for goal oriented mutual funds (retirement, education, housing, medical expenses). FI-2

  35. Cash Flow Matching and Dedication Is a very reasonable strategy, but not always realizable. Uncertainty of payments. Lack of perfect match Saving on transaction fees. FI-2

  36. Active Bond Management Mainly speculative approach based on ability to predict IR or credit enhancement or market imperfections (identifying mispriced loans). FI-2

  37. Substitution Swap Exchange of one bond for a very similar bond. Motivation: belief that one of them is mispriced. Example: 20-yr, 9% coupon Ford Motor bond callable after 5 years at $1,050 versus a 9% coupon Chrysler bond with 20 yr to maturity. FI-2

  38. Contingent Immunization value $12,000 $10,000 0 5 yr t FI-2

  39. Contingent Immunization value $12,000 $10,000 Stop boundary 0 5 yr t FI-2

  40. value $12,000 $10,000 Stop boundary 0 5 yr t Contingent Immunization FI-2

  41. value $12,000 $10,000 Stop boundary 0 5 yr t Contingent Immunization FI-2

  42. Interest Rate Swap One of the major fixed-income tools. Example: 6m LIBOR versus 7% fixed. Exchange of net cash flows. Risk involved: IR risk, default risk (small). Why the default risk on IR swaps is small? FI-2

  43. LIBOR LIBOR Interest Rate Swap 7.05% 6.95% Company B Swap dealer Company A No need in an actual loan. Can be used as a speculative tool or for hedging. FI-2

  44. Currency Swap A similar exchange of two loans in different currencies. Subject to a higher default risk, because of the principal. Is useful for international companies to hedge currency risk. FI-2

  45. The Treasuries Securities Market US Treasury debt $3.6Trillion daily transactions: $190B yields are viewed as benchmarks 1776, first US issue (Revolutionary War) Increase during the Civil war, WW1, tripled during the great depression exploded during WW2. FI-2

  46. Types of Treasuries securities • $3.2T - marketable • Bills - up to one year • Notes 1-10 years when issued • Bonds longer then 10 years • 57% are notes, 20% bills and 20% bonds. • Some are callable (by the Treasury) • 97% are nominal FI-2

  47. Nonmarketable securities • Government account series (83%) • State and Local Government Series (7%) • saving bonds (7%) held by off-budget government programs, like social security, local governments, etc. yield is at least 5bp below marketable Treasuries. FI-2

  48. Issuance of Treasuries • regularly scheduled auctions = primary market. • 2,000 brokers and dealers are registered • Prime dealers are selected by NY Fed - counterparites for open market operations. FI-2

  49. Auctions • The process begins several days before. • “when issued market” after the announcement but before it takes place. • On the day of the auctions bids may be submitted to FED. • Competitive bids - quantity and yield • Noncompetitive bids - small orders FI-2

  50. Auctions • Uniform price method for 2, 5 year notes, TIPS • Other issues have multiple price auction • Bidders get securities at their bid price. • Non-competitive get at the average price of competitive bids. FI-2

More Related