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Chapter 11

Chapter 11. Managing Fixed-Income Investments. Managing Fixed Income Securities: Basic Strategies. Active strategy Trade on interest rate predictions Trade on market inefficiencies Passive strategy Control risk Balance risk and return. Bond Pricing Relationships.

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Chapter 11

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  1. Chapter11 Managing Fixed-Income Investments

  2. Managing Fixed Income Securities: Basic Strategies • Active strategy • Trade on interest rate predictions • Trade on market inefficiencies • Passive strategy • Control risk • Balance risk and return

  3. Bond Pricing Relationships • Inverse relationship between price and yield • An increase in a bond’s yield to maturity results in a smaller price decline than the gain associated with a decrease in yield • Long-term bonds tend to be more price sensitive than short-term bonds

  4. Bond Pricing Relationships (cont.) • As maturity increases, price sensitivity increases at a decreasing rate • Price sensitivity is inversely related to a bond’s coupon rate • Price sensitivity is inversely related to the yield to maturity at which the bond is selling

  5. 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

  6. Duration: Calculation

  7. Duration Calculation

  8. Duration/Price Relationship Price change is proportional to duration and not to maturity DP/P = -D x [D(1+y) / (1+y) D* = modified duration D* = D / (1+y) DP/P = - D* x Dy

  9. Uses of Duration • Summary measure of length or effective maturity for a portfolio • Immunization of interest rate risk (passive management) • Net worth immunization • Target date immunization • Measure of price sensitivity for changes in interest rate

  10. Pricing Error from Convexity Price Pricing Error from Convexity Duration Yield

  11. Correction for Convexity Modify the pricing equation: Convexity is Equal to: Where: CFt is the cashflow (interest and/or principal) at time t.

  12. Active Bond Management: Swapping Strategies • Substitution swap • Intermarket swap • Rate anticipation swap • Pure yield pickup • Tax swap

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