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CFA Level 3 > Fixed-Income Portfolio Management, Liability-Driven and Index-Based Strategies > Flashcards

Fixed-Income Portfolio Management, Liability-Driven and Index-Based Strategies Flashcards

1
Q

Immunization

A
  • Is the process of structuring and managing a fixed-income portfolio to minimize the variance in the realized rate of return and to lock in the cash flow yield (internal rate of return) on the portfolio
  • The cash flow yield is not the weighted average of the yields to maturity on the bonds that constitute the portfolio
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2
Q
  • Asset–liability management
  • Liability-driven investing
  • Asset-driven liabilities
A
  • Asset–liability management strategies consider both assets and liabilities
  • Liability-driven investing takes the liabilities as given and builds the asset portfolio in accordance with the interest rate risk characteristics of the liabilities
  • Asset-driven liabilities take the assets as given and structures debt liabilities in accordance with the interest rate characteristics of the assets
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3
Q

Approaches to liability-based mandates

A
  • Cash flow matching
  • Duration matching
  • Contingent immunization
  • Horizon matching (also called combination matching)
  • Derivative overlay
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4
Q

Liability-based approaches - key features

A
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5
Q

Total return approaches - key features

A
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6
Q

Zero replication

A

In reference to a zero-coupon bond, means that a liability has been immunized

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7
Q

Contingent immunization

A

Combines immunization with an active management approach when the asset portfolio’s value exceeds the present value of the liability portfolio

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8
Q

Horizon matching (also called combination matching)

A

Short-term liabilities are covered by a cash flow matching approach while long-term liabilities are covered by a duration matching approach

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9
Q

Symmetric cash flow matching

A
  • A cash flow matching technique that allows cash flows occurring both before and after the liability date to be used to meet a liability
  • Allows for the short-term borrowing of funds to satisfy a liability prior to the liability due date
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10
Q

Expected fixed-income return

A

E(R) ≈

  • Yield income +
  • Rolldown return +
  • E(Change in price based on investor’s views of yields and yield spreads) −
  • E(Credit losses) +
  • E(Currency gains or losses)
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11
Q

Yield income (or Current yield)

A

= Annual coupon payment/Current bond price

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12
Q

Rolldown return

A
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13
Q

The expected change in price based on investor’s views of yields and yield spreads

A
  • ∆Yield input (55 bps is to be input as 0.0055)
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14
Q

Rolling yield

A

= yield income + rolldown return

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15
Q

Leveraged portfolio return

A
  • VE = value of the portfolio’s equity
  • VB = borrowed funds
  • rB = borrowing rate (cost of borrowing)
  • rI = return on the invested funds (investment returns)
  • rp = return on the levered portfolio
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16
Q

The futures leverage

A
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17
Q

REPO dollar interest

A
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18
Q

Rebate rate on securities lending

A
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19
Q

Convexity and duration with and without embedded options

A
  • With embedded options ⇒ use effective duration and effective convexity
  • Without embedded options ⇒ use modified duration and convexity
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20
Q

Types of fixed-income risks

A
  • Non MBS securities
    • Interest rate
    • Yield curve
    • Spread
    • Credit
    • Optionality
  • MBS securities
    • Sector
    • Prepayment
    • Convexity
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21
Q

Tracking risk (also called active risk or tracking error)

A
  • The standard deviation of the portfolio’s active return
  • Active return = Portfolio’s return – Benchmark index’s return
  • Tracking risk = Standard deviation of the active returns
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22
Q

Total return

A

The rate of return that equates the future value of the bond’s cash flows with the full price of the bond. The total return takes into account all three sources of potential return: coupon income, reinvestment income, and change in price

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23
Q

The bond equivalent yield (BEY)

A
  • The BEY is a calculation for restating semi-annual, quarterly or monthly discount bond or note yields into an annual yield
  • Example: 7.5% on a BEY is 3.75% every six months
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24
Q

Effective duration definition

A

Measures the sensitivity of the price to a relatively small parallel shift in interest rates (interest rate risk)

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25
Q

Key rate duration definition (also called multifunctional or functional duration)

A

Measures the sensitivity of the price to nonparallel shift in interest rates. Takes into account rate changes in a specific maturity along the yield curve (yield curve risk)

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26
Q

Macaulay duration formula

A
  • t = the number of days from the last coupon payment to the settlement date
  • T = the number of days in the coupon period
  • t/T = the fraction of the coupon period that has gone by since the last payment
  • PMT = the coupon payment per period
  • FV = the future value paid at maturity, or the par value of the bond
  • r = the yield-to-maturity, or the market discount rate, per period
  • N = the number of evenly spaced periods to maturity as of the beginning of the current period
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27
Q

Macaulay duration for a zero-coupon bond

A

Is equal to its maturity

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28
Q

Modified duration

A

= Macaulay duration / (1 + cash flow yield)

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29
Q

Effective duration formula

A
  • PV0 is the initial value
  • PV– is the new value after the yield curve is lowered by ΔCurve
  • PV+ is the value after the yield curve is raised by ΔCurve
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30
Q

Dollar duration (also called money duration)

A

= price * modified duration

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31
Q

Spread duration

A

Refers to the change in a non-Treasury security’s price given a widening or narrowing of the spread compared with the benchmark

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32
Q

Basis Point Value (BPV)

A

Is a measure of money duration calculated by multiplying the money duration by 0.0001

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33
Q

Portfolio modified adjusted duration

A

Takes into account option-adjusted duration

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34
Q

Convexity relation to the Macaulay duration

A
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35
Q

Annualizing Macaulay duration, dipersion and convexity

A
  • Macaulay duration ⇒ divide by the periodicity of the bond
  • Dispersion and convexity ⇒ divide by the periodicity2 of the bond
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36
Q

Dispersion statistic

A

Dispersion is the weighted variance. It measures the extent to which the payments are spread out around the duration

37
Q

Dispersion statistic individual cash flow contribution

A
  • = (T - Macaulay duration)2 * weight
  • T is the integer position of the cash flow (1, 2, 3, 4…)
38
Q

Convexity statistic individual cash flow contribution

A
  • = (N * (N + 1) * weight)
  • N is the integer number of the cash flow (1, 2, 3, 4…)
39
Q

Convexity from the sum of individual cash flow contribution

A

= [Σ of individual cash flow contribution to convexity / (1 + effective annual cash flow yield/n)n] / 4

  • n = number of period per year
40
Q

Futures BPV

A
  • CTD = Cheapest-to-deliver
  • CF = Conversion factor
  • In interest futures markets that do not have a CTD security, the Futures BPV is simply the BPV of the deliverable bond
41
Q

Number of futures required to rebalance the BPV of the portfolio

A
42
Q

3 major types of spread

A
  • Nominal spread ⇒ the spread of a bond or portfolio above the yield of a certain maturity Treasury
  • Static spread or zero-volatility spread ⇒ the yield spread that must be added to each point of the implied spot yield curve to make the present value of a bond’s cash flows equal its current market price
  • Option-adjusted spread (OAS) ⇒ the constant spread that, when added to all the one-period forward rates on the interest rate tree, makes the arbitrage-free value of the bond equal to its market price
43
Q

Portfolio duration versus spread duration

A
  • For a portfolio of non-Treasury securities, spread duration equals portfolio duration
  • For a portfolio that includes both Treasury and non-Treasury securities, spread duration is different from the portfolio duration because the spread duration of Treasury securities is zero
44
Q

Economic surplus of the portfolio

A

The market value of assets minus the present value of liabilities

45
Q

Accumulated Benefits Obligation (ABO)

A
  • G is the number of years worked
  • m is a multiplier
  • The term in brackets is the value of the Z-year annuity as of year T, and that sum is discounted back over T years to Time 0 (w0)
46
Q

Projected Benefits Obligation (PBO)

A
  • G is the number of years worked
  • m is a multiplier
  • WT = W0 × (1 + w)T
  • w is the average annual wage growth rate for the employee’s remaining work life of T years
47
Q

The notional principal (NP) on an interest rate swap needed to close the duration gap to zero

A
  • When the Swap BVP is quoted per $100 of notional principal
48
Q
  • Barbell portfolio
  • Bullet portfolio
A
  • A portfolio made up of short and long maturities relative to the horizon date and interim coupon payments
  • A portfolio made up of bond with maturities that are very close to the investment horizon
49
Q

Swaption

A
  • Option to enter a fixed-rate swap
  • The receiver swaption receives the fixed rate
  • The payer swaption pays the fixed rate
50
Q

Laddered, bullet and barbell portfolio visual depiction

A
51
Q

Payoffs on Received-Fixed Swap, Receiver Swaption, and Swaption Collar

A
  • If the plan manager expects the swap rate to be at or below 4.16%, the receive-fixed swap is preferred
  • If the manager expects the swap rate to be above 4.16% the swaption collar is preferred
  • At some point above 5.00%, the purchased receiver swaption is better because it limits the loss. That breakeven rate can be found by trial-and-error search
52
Q

Full interest rate hedging relation

A
53
Q

Multiple liability immunization versus cash flow matching

A
  • Multiple liability immunization and cash flow matching approaches do not have the same risks and costs
  • Cash flow matching generally has less risk of not satisfying future liabilities
  • Multiple liability immunization generally costs less
54
Q

The conditions to immunize multiple liabilities

A
  1. The market value of assets is greater than or equal to the market value of the liabilities
  2. The assets BPV equals the liabilities BPV
  3. The dispersion of cash flows and the convexity of assets are greater than those of the liabilities
55
Q

The conditions to immunize a single liability

A
  1. The immunization strategy is to match the portfolio Macaulay duration with the investment horizon
  2. The initial investment needs to match (or exceed) the present value of the liability

*The portfolio should minimize the convexity statistic

56
Q

Type of products which have negative convexity

A
  • Callable bonds
  • Mortgage-backed securities
  • High-coupon issues have less convexity than low-coupon issues
57
Q

Duration matching when the market values of the assets and liabilities differ

A

Should match the money duration, in particular the BPV

58
Q

Duration of an option

A
59
Q

Dollar duration of a swap

A
60
Q

Total Return Analysis

A

Analysis of the expected effect of a trade on the portfolio’s total return, given an interest rate forecast

61
Q

Portfolio rate of return using borrowed funds

A
  • k = borrowing rate
  • rf = portfolio rate of return
62
Q

Immunize a portfolio to nonparallel shift in the yield curve

A

Applying functional duration or key rate durations allows durations along the yield curve to match those of the liabilities. A nonparallel shift in the yield curve will affect assets and liabilities in an offsetting manner.

63
Q

Cash flow matching rate of return requirements

A

Cash flow matching requires a relatively conservative rate-of-return assumption for short-term cash, and cash balances may occasionally be substantial

64
Q

Hedging ratio

A

The percentage of the duration gap that is closed with the derivatives

65
Q
  • Basis
  • Basis risk
A
  • The difference between the cash price and the futures price
  • The risk that the basis will change in an unpredictable way
66
Q

Model risk

A

Arise in LDI strategies because of the many assumptions in the models and approximations used to measure key parameters

67
Q

Spread risk

A

Arises in LDI strategies because it is common to assume equal changes in asset, liability, and hedging instrument yields

68
Q

Counterparty credit risk

A

The risk that the counterparty defaults when time comes to meet its obligation

69
Q

Collateral risk

A

The risk the the counterparty has exhausted its availble collateral and is unable to mark-to-market its position

70
Q

Structural risk

A
  • Arises from some non-parallel shifts and twists to the yield curve
  • This risk is reduced by minimizing the dispersion of cash flows in the portfolio, which can be accomplished by minimizing the convexity statistic for the portfolio. Concentrating the cash flows around the horizon date makes the immunizing portfolio closely track the zero-coupon bond that provides for perfect immunization
71
Q

Primary indexing risk factors

A
  • Portfolio modified adjusted duration
  • Key rate duration
  • Percent in sector and quality
  • Sector and quality spread duration contribution
  • Sector/coupon/maturity cell weights
  • Issuer exposure
72
Q

Pure bond indexing (or full replication approach)

A

The pure bond indexing approach attempts to duplicate the index by owning all the bonds in the index in the same percentage as the index

73
Q

Enhanced indexing by matching primary risk factors

A

This management style uses a sampling approach in an attempt to match the primary index risk factors and achieve a higher return than under full replication (also called stratified or cell approach)

74
Q

Enhanced indexing by small risk factor mismatches

A

While matching duration (interest rate sensitivity), this style allows the manager to tilt the portfolio in favor of any of the other risk factors. The manager may try to marginally increase the return by pursuing relative value in certain sectors, quality, term structure, and so on

75
Q

Alpha of fixed income managers

A

For long periods, when fund fees and expenses are factored in, the realized alpha of fixed-income managers has averaged close to zero with little evidence of persistence

76
Q

Convexity in duration matching

A
  • Higher convexity is better
  • To immunize multiple liabilities, the convexity (and dispersion of cash flows) of the assets needs to be greater than the liabilities
77
Q

Matrix pricing (also called evaluated pricing)

A

Matrix pricing makes use of observable liquid benchmark yields of similar maturity and duration as well as the benchmark spreads of bonds with comparable times to maturity, credit quality, and sector or security type in order to estimate the current market yield and price

78
Q

Present value of distribution of cash flows methodology

A

An approach that seeks to approximate and match the yield curve risk of an index over discrete time periods referred to as cash flow vertices

79
Q

Enhancement strategies seeking to reduce the component of tracking error associated with the expenses and transactions costs of portfolio

A
  • Lower cost enhancements
  • Issue selection enhancements
  • Yield curve enhancements
  • Sector/quality enhancements
  • Call exposure enhancements
80
Q

Total return swap (TRS) mechanic

A
81
Q

Highest to lowest convexity for portfolio structure

A
  1. Barbell
  2. Laddered
  3. Bullet
82
Q

Accounting defeasance (also called in-substance defeasance)

A

Is a way of extinguishing a debt obligation by setting aside sufficient high-quality securities to repay the liability

83
Q

Classification of Liabilities

A
84
Q

The “bums” problem

A

As a particular issuer or sector of the economy borrows more, investors tracking a value-weighted index will automatically increase their fixed-income exposure to these borrowers

85
Q

Requirements for an appropriate benchmark portfolio

A
  • Clear, transparent rules for security inclusion and weighting
  • Investability
  • Daily valuation
  • Availability of past returns and turnover
86
Q

Laddered portfolio advantages

A
  • Offers diversification over the yield curve
  • Provides liquidity as it always contains soon-to-mature bonds
87
Q

Bond tender offer

A

A corporate finance term denoting the process of a firm retiring its debt by making an offer to its bondholders to repurchase a specific number of bonds at a specified price and specified time. Firms use these offers to refinance or restructure their current capital structure

88
Q

Most relevant considerations for:

  1. Investment-grade bonds
  2. High-yield bonds
A
  1. Investment-grade bonds
    • Credit migration (or credit downgrade) risk
    • Spread risk
    • Interest rate risk
  2. High-yield bonds
    • Credit risk
89
Q

Causes of liability noise

A
  • Plan demographic experience differing from the actuary’s model even if the underlying probabilities were certain
  • Model uncertainty—the fact that the underlying probabilities are not certain (e.g., mortality rate change due to medical innovations)

CFA Level 3 (19 decks)

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