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CHAPTER TWENTY-TWO

CHAPTER TWENTY-TWO. BOND PORTFOLIO MANAGEMENT. BOND PORTOLIOS. METHODS OF MANAGEMENT Passive rests on the belief that bond markets are semi-strong efficient current bond prices viewed as accurately reflecting all publicly available information. BOND PORTOLIOS. METHODS OF MANAGEMENT Active

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CHAPTER TWENTY-TWO

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  1. CHAPTER TWENTY-TWO BOND PORTFOLIO MANAGEMENT

  2. BOND PORTOLIOS • METHODS OF MANAGEMENT • Passive • rests on the belief that bond markets are semi-strong efficient • current bond prices viewed as accurately reflecting all publicly available information

  3. BOND PORTOLIOS • METHODS OF MANAGEMENT • Active • rests on the belief that the market is not so efficient • some investors have the opportunity to earn above-average returns

  4. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS • for a typical bond making periodic coupon payments and a terminal principal payment

  5. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS • THEOREM 1 • If a bond’s market price increases • then its yield must decrease • conversely if a bond’s market price decreases • then its yield must increase

  6. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS • THEOREM 2 • If a bond’s yield doesn’t change over its life, • then the size of the discount or premium will decrease as its life shortens

  7. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS • THEOREM 3 • If a bond’s yield does not change over its life • then the size of its discount or premium will decrease • at an increasing rate as its life shortens

  8. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS • THEOREM 4 • A decrease in a bond’s yield will raise the bond’s price by an amount that is greater in size than the corresponding fall in the bond’s price that would occur if there were an equal-sized increase in the bond’s yield • the price-yield relationship is convex

  9. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS • THEOREM 5 • the percentage change in a bond’s price owing to a change in its yield will be smaller if the coupon rate is higher

  10. CONVEXITY CONVEXITY DEFINITION: • a measure of the curvedness of the price-yield relationship

  11. CONVEXITY • THE PRICE-YIELD RELATIONSHIP Price YTM

  12. CONVEXITY • THEOREM 1 TELLS US • price and yield are inversely related but not in a linear fashion (see graph) • an increase in yield is associated with a drop in bond price • but the size of the change in price when yield rises is greater than the size of the price change when yield falls

  13. DURATION • DEFINITION: • measures the “average maturity” of a stream of bond payments • it is the weighted average time to full recovery of the principal and interest payments

  14. DURATION • FORMULA where P0 = the current market price of the bond PV(Ct )= the present value of the coupon payments t = time periods

  15. DURATION • THE RELATION OF DURATION TO PRICE CHANGES • THEOREM 5 implies • bonds with same maturity date but different coupon rates may react differently to changes in the interest rate • duration is a price-risk indicator

  16. DURATION • DURATION IS A PRICE-RISK INDICATOR • FORMULA rewritten where y = the bond’s yield to maturity

  17. DURATION • MODIFIED DURATION • FORMULA: • reflects the bond’s % price change for a one percent change in the yield

  18. DURATION • THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION • whereas duration would have us believe that the relationship between yield and price change is linear • convexity shows us otherwise

  19. DURATION • THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION P C YTM 0

  20. IMMUNIZATION • DEFINITION: a bond portfolio management technique which allows the manager to be relatively certain of a given promised cash stream

  21. IMMUNIZATION • HOW TO ACCOMPLISH IMMUNIZATION • Duration of a portfolio of bonds • equals the weighted average of the individual bond durations in the portfolio • Immunization • calculate the duration of the promised outflows • invest in a portfolio of bonds with identical durations

  22. IMMUNIZATION • PROBLEMS WITH IMMUNIZATION • default and call risk ignored • multiple nonparallel shifts in a nonhorizontal yield curve • costly rebalancing ignored • choosing from a wide range of candidate bond portfolios is not very easy

  23. ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT • Horizon Analysis • simple holding period selected for analysis • possible yield structures at the end of period are considered • sensitivities to changes in key assumptions are estimated

  24. ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT • Bond Swapping • exchanging bonds to take advantage of superior ability to predict yields • Categories: • substitution swap • intermarket spread swap • rate anticipation swap • pure yield pickup swap

  25. ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT • Contingent Immunization • portfolio managed actively as long as favorable results are obtained • if unfavorable, then immunize the portfolio

  26. PASSIVE MANAGEMENT • TYPES OF PASSIVE MANAGEMENT • INDEXATION • the portfolio is formed to track a chosen index

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