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Chapter 16

Chapter 16. Fixed-Income Portfolio Management. 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 16

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1. Chapter 16 Fixed-IncomePortfolio Management 16-1

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 16-2

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 16-3

4. Bond Pricing Relationships (cont’d) • 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 16-4

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 16-5

6. 8% Time Payment PV of CF Weight C1 X Bond years (10%) C4 .5 40 38.095 .0395 .0198 1 40 36.281 .0376 .0376 1.5 40 34.553 .0358 .0537 2.0 1040 855.611 . 8871 1.7742 sum 964.540 1.000 1.8853 Duration Calculation: Example using Table 16.3 16-7

7. Duration/Price Relationship Price change is proportional to duration and not to maturity P/P = -D x [(1+y) / (1+y) D* = modified duration D* = D / (1+y) P/P = - D* x y 16-8

8. Rules for Duration Rule 1 The duration of a zero-coupon bond equals its time to maturity Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate is lower Rule 3 Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity Rule 4 Holding other factors constant, the duration of a coupon bond is higher when the bond’s yield to maturity is lower 16-9

9. Rules for Duration (cont’d) Rules 5 The duration of a level perpetuity is equal to: Rule 6 The duration of a level annuity is equal to: 16-10

10. Rules for Duration (cont’d) Rule 7 The duration for a corporate bond is equal to: 16-11

11. Passive Management • Bond-Index Funds • Immunization of interest rate risk • Net worth immunization Duration of assets = Duration of liabilities • Target date immunization Holding Period matches Duration • Cash flow matching and dedication 16-12

12. Price Pricing Error from convexity Duration Duration and Convexity Yield 16-13

13. Correction for Convexity Correction for Convexity: 16-14

14. Active Bond Management: Swapping Strategies • Substitution swap • Intermarket swap • Rate anticipation swap • Pure yield pickup • Tax swap 16-15

15. Yield Curve Ride Yield to Maturity % 1.5 1.25 .75 Maturity 3 mon 6 mon 9 mon 16-16

16. Contingent Immunization • Combination of active and passive management • Strategy involves active management with a floor rate of return • As long as the rate earned exceeds the floor, the portfolio is actively managed • Once the floor rate or trigger rate is reached, the portfolio is immunized 16-17

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