Cfa Level Iii - Study Session 10

Front 1

Portfolio Management of Global Bonds and FI Derivatives

Effects of leverage
(SS10)

Back 1

Effects of leverage cut both ways
1. Amplifies positive returns
2. Magnifies negative returns
3. The higher the leverage the higher the risk. Duration is higher for a leveraged portfolio.
4. The greater the variability on the annual return on the invested funds, the greater the risk (variation in potential outcomes).
5. Split into:
return on assets 140 @ 4.5%
interest on liability 100 @ 4%
return on borrowing (4.5 - 4%)
return on equity
$6.2 - $4
---------------- 5.75%
$40

Front 2

Portfolio Management of Global Bonds and FI Derivatives

Repurchase Agreements
(SS10)

Back 2

A repurchase is the favourite means by which to leverage.
i. the repo market presents a low-cost way for managers to borrow funds by providing Treasury securities as collateral.
ii. repo rate is a SECURED LOAN, so it doesn't depend on the respective parties' credit qualities.

Front 3

Portfolio Management of Global Bonds and FI Derivatives

Repo Rate is affected by
(SS10)

Back 3

1. Quality of collateral - higher the quality the lower the repo
2. Term of the repo - shorter the maturity the lower the repo
3. Delivery requirment - physical delivery gets a lower repo because of lower default risk
4. Availability of collateral - if a bank wants a certain type of security then they may agree to loan at a lower rate
5. Prevailing interest rates in the economy
6. Seasonal factors - supply and demand at different times of the year/economic cycle.

Front 4

Portfolio Management of Global Bonds and FI Derivatives

Maintaining portfolio duration in changing portfolio holdings - example
(SS10)

Back 4

A portfolio manager wants to exchange one bond issue for another that he believes is undervalued. The existing old bond MV = $5.5m. The bond has a price of $80 and a duration of 4.
The bond's dollar duration is therefore 5.5m x 4/100 or $220,000.
The new bond has a duration of 5 and a price of $90, resulting in a dollar duration of 4.5 ($90 x 5/100) per bond. What is the par value of the new bond needed to keep the duration of the pf constant?

$220,000
------------- x 100 = $4.889 million
4.5

Dollar duration of old/duration of new

Front 5

Portfolio Management of Global Bonds and FI Derivatives

Other risk measures
(SS10)

Back 5

1. Semi-variance
GOOD theoretically superior
BAD computationally challenging
BAD big bad returns are hard to forecast anyway
2. Shortfall risk (or risk of loss) - focuses on that part of the distribution that represents the downside from the designated return level.
BAD shortfall does not account for loss in money terms
3. Value at risk (VAR) is an estimate of loss in money terms
BAD because it doesn't indicate the magnitude of the very worst posible outcomes.

Front 6

Portfolio Management of Global Bonds and FI Derivatives

Dollar durations of fixed vs floating swap
(SS10)

Back 6

1. Dollar duration of a floating-rate bond is SMALL
2. Dollar duration for a fixed-rate bond is high (compared to a floating-rate bond)

Front 7

Portfolio Management of Global Bonds and FI Derivatives

Three types of credit risk
(SS10)

Back 7

1. Default risk - fail to meet it's obligation
2. Credit spread risk - spread of a risky bond and the rate for a US treasury may vary after purchase.
3. Downgrade risk - risk that a rating agency downgrades its rating for an issuer.

You can transfer this risk with derivatives
i. Credit Options - triggered by value of underlying asset or a spread change over the risk free
Binary Credit options = 1 if you default and 0 otherwise
ii. Credit Forwards
iii. Credit Swaps

Front 8

Portfolio Management of Global Bonds and FI Derivatives

Binary credit option - example
(SS10)

Back 8

5,000 bonds with a par of $1,000 each. Manager buys a binary credit put option expiring in 6 months and pays if the rating of Alpha Motors' bond on expiration date is BB or lower.
The payoff (if any) is the difference between the strike price and the value of the bond at expiration. The fund paid premium of $130,000 to purchase the option on 5,000 bonds.
1. What is the payoff if on expiration the rating is C and the value of the bond is $570.
Answer
i. Bond is IN the money at expiration because rating is below investment grade
ii. Therefore payoff is $1,000 - $870 = $130
Payoff on 5,000 bonds is x $130
= $650,000
iii. The profit is $650,000 - $130,000 = $520,000
2. What is the payoff and profit if the rating of Alpha on expiration date is investment grade and the value of the bond is $980?
i. Can't exercise because rating is investment grade
ii. Payoff - none
iii. Profit - $130,000 loss of the option premium paid

Front 9

Portfolio Management of Global Bonds and FI Derivatives

Example - Credit Forwards
(SS10)

Back 9

Current spread of HiFi bonds relative to gov debt is 200 bps. Manager thinks credit situation will deteriorate leading to higher spreads on its bonds.
He buys a 6 month credit forward (remember risk factor here) with the current spread as the contracted spread. Forward has a notional of $5m and a risk factor of 4.3
1. On settlement HiFicredit spread 150bps. How much is the payoff to Sable
= (.015 - .02) x $5m x 4,3
= - $107,500 , so a loss
2. What is the payoff if the credit spread is 300bps
= (0.03 - 0.03) x $5m x 4.3
= $215,000 profit

Front 10

Portfolio Management of Global Bonds and FI Derivatives

Credit Swaps
(SS10)

Back 10

Credit Default Swaps (most popular)
i. Shift credit exposure of an asset from one investor (protection buyer) to another investor (protection seller).
ii. Settlement to these when the seller ends up sometimes paying the buyer are
physical delivery
negotiated cash payment equivalent to MV of securities.
iii. Default swaps advantages are that they are good for non-publicly traded debts and more flexible.

Front 11

Portfolio Management of Global Bonds and FI Derivatives

Duration Management when International Bonds enter the picture
(SS10)

Back 11

Duration is based on the concept of 100bps shift.
If you add international bonds in, EVERY country in the portfolio has to change 100bps.
Since internationals aren't perfectly correlated these aren't going to happen at the same time.
Have to add in the CORRELATION somehow.
Contribution of international durations change to the portfolio
= - Duration
x change in foreign yield given a change in domestic
x 100
= change in value of foreign bond

Front 12

Portfolio Management of Global Bonds and FI Derivatives

3 methods of currency hedging
(SS10)

Back 12

1. Forward hedging (most popular) - forward contract between the bond's currency and the home currency
2. Proxy hedging - between home currency and a currency that is highly correlated with the bond's currency
3. Cross hedging - using 2 currencies other than the home currency.

If the investor can hedge fully with forwards, the the return they'll make is the (fully) hedged return
= rl + f
where rl is the foreign bond return in local currency
f is the forward discount (premium)

Front 13

Portfolio Management of Global Bonds and FI Derivatives

Comparing Hedged Returns across Markets
(SS10)

Back 13

A UK investor is making a choice between same maturity (and credit risk) Japanese and Canadian gov. bonds. Note here that you are in the UK, but both bonds are NON UK, so look for the local risk premiums. (Not discounts/premiums) Currently 10-y yields on gov bonds
Japan = 2.16%
Canada = 3.4%
Short-term interest rates
Japan = 1.25%
Canada = 1.54%
Answer
1. Japan's gov bond's LOCAL risk premium is
0.91 = 2.16 - 1.25
2. Canadian gov bond's LOCAL risk premium is
1.86 = 3.4 - 1.54
So, because the local risk premium on the Canadian bond is higher, its expected fully hedged return will be high as well.

Front 14

Portfolio Management of Global Bonds and FI Derivatives

Example - To hedge or not with a Forward Contract
(SS10)

Back 14

French investor, who holds UK and French bonds.
Short term ir France = 3.2%
Short term ir UK = 4.7%
Therefore forward discount if you are standing in France is 4.7 - 3.2 = 1.5 appreciation of UK pound
1. If French guy uses a forward contract, he locks in the currency return of -1.5%, i.e. a 5% loss on the currency. By being unhedged, he expects the loss on currency to be less than 1.5%. Since he expects this, he shouldn't hedge
2. From the UK guys perspective, he would lock in a return of 1.5% (UK pound appreciating). If he expects the appreciation to be less than 1.5% then he should hedge because he can lock in 1.5%. This is because the 1.5% is the interest rate differential that he can lock in by hedging the currency.

Front 15

Portfolio Management of Global Bonds and FI Derivatives

Breakeven Spread Analysis
(SS10)

Back 15

Breakeven
i. Doesn't think about ER risk
ii. Does think about duration
iii. It's all about the yield advantage disappearing if domestic yields increase and foreign yields decline. (You're trying to 'play' overseas when you would've been better off at home)
iv. Has to happen across a horizon that you have in mind (not just indefinite time period)

Front 16

Portfolio Management of Global Bonds and FI Derivatives

Example - Breakeven Spread Analysis
(SS10)

Back 16

Spread between Japan and French bonds is 300bps, giving Japanese investors who bought French bonds an additional yield income of 75bps per quarter. Duration of Jap bonds is 7.
With a duration of 7, the price change for the Japanese bond will be seven times the change in yield. (For 100bps change, Jap changes 7%)
Change in price = 7 x Change in yield
0.75 percent = 7 x W
Therefore W = 0.1071 (10.71 bps)

Thus a spread widening of 10.71 bps because of a decline in the yields in Japan would wipe out the additional yield gained from investing in the French bond for that quarter. (Remember it is across a finite length of time)

Front 17

Portfolio Management of Global Bonds and FI Derivatives

Emerging Market Debt
(SS10)

Back 17

Advantages of emerging market
i. Attractive rates of return.
ii. Government can change fiscal policy to make repayment of debt more within their control.
Disadvantages of emerging market
i. Negative skewness i.e. big bad returns
ii. No big similar upside
iii. Poor transparency
iv. Less developed legal system
iv. Higher political risk - risk of war, government collapse, repatriation of earnings or assets.

Front 18

Portfolio Management of Global Bonds and FI Derivatives

Selecting a fixed-income manager (the active one, not the passive one)
(SS10)

Back 18

1. Should you choose one based on historical performance? NO, the positive returns may persist over a short period of time, but studies show that they don't over longer periods of time.
2. Selection criteria
i. Style analysis
ii. Selection bets
iii. The organisation's investment process
iv. Correlation of alphas - alphas across managers, some have similar styles of management. If you use multiple managers, you want a low correlation between them to control risk.

Front 19

Hedging Mortgage Securities to Capture Relative Value

Main characteristic of MBS
(SS10)

Back 19

1. Has both positive AND negative convexity. (mostly negative)
This means that the price increase when interest rates decline is less than the price decrease when interest rates rise.
2. All due to the prepayment option. When ir goes down, people prepay and refinance at lower rates
3. The holder of the MBS gets the bad deal because if it's repaid they have to go out an invest it at lower rates.
4. Value of MBS = Value of Treasury - Value of prepayment option
When ir go down, the value of a MBS increases, but not by as much as a Treasury because the increase in the value of the prepayment option offsets part of the price appreciation.

Front 20

Hedging Mortgage Securities to Capture Relative Value

Why do people think MBS's are market directional securities
(SS10)

Back 20

1. If you think they are market directional you should avoid them when one expects interest rates to decline
2. BUT when properly managed (with proper hedging) by separating the mortgage valuation decision from decisions concerning the appropriate duration of the portfolio they are NOT market directional.
3. If hedged improperly, the portfolio's duration will be shorter than desired when interest rates decline and longer than desired when interest rates rise.
4. Duration hedge is going to make it look like MARKET DIRECTIONAL. Duration forgets impacts from the twist.
Two bond hedge suggests that MBS's are non-market directional. 2-bond remembers impact of twist.

Front 21

Hedging Mortgage Securities to Capture Relative Value

The 5 Mortgage Security Risks
(SS10)

Back 21

1. Spread risk - (don't want to hedge this)
2. Interest rate risk - (hedge this)
3. Prepayment risk - if ir goes down people payoff and therefore duration goes down. You have to dynamically hedge to get duration back up.
4. Volatility risk
5. Model risk

Split into two components
i. Treasury return on an equal ir security
ii. Plus a spread = option cost + OAS

Option cost = prepayment risk
OAS = volatility and model risk.

Front 22

Hedging Mortgage Securities to Capture Relative Value

Volatility Risk
(SS10)

Back 22

OAS widens when expected volatility increases and narrow when expected volatility declines.
1. When volatility is priced too expensively
HEDGE DYNAMICALLY
2. When volatility is priced too cheaply buy the options (note: you can make use of options here, whereas on the other side you have to hedge dynamically)

Most common scenario is implied volatility is priced higher than the volatility that is actually realised.

Front 23

Hedging Mortgage Securities to Capture Relative Value

Can you hedge model risk?
(SS10)

Back 23

NO, you can't hedge model risk
i. Think the conditional prepayment CPR rates here of 40% when they are actually 60%.
ii. To overcome model risk use scenario analysis using a variety of prepayment rates
iii. Can't always use past rates or historical data, because things may've innovated past that since then.
iv. Can't hedge model risk, but you can measure it.

Front 24

Hedging Mortgage Securities to Capture Relative Value

Two Bond Hedge
(SS10)

Back 24

1i. Find MBS up/down ir Price
ii. Find 2 yr Treasury up/down ir Price
iii. Find 10 yr Treasury up/down ir Price
You should have 6 price change amounts
2. Average them
You should have 3 averages
Make a simultaneous equation with them.

3i. Find MBS flat/steep ir Price
ii. Find 2 yr Treasury flat/steep ir Price
iii. Find 10 yr Treasury flat/steep ir Price
4. Average them
You should have 3 averages
Make an equation with them
5. Use simultaneous equations to solve for H2 and H10
Remember to use -ve for the -MBS price

NB: It is possible to have positive and/or negative values for H2, H10. Negative means short, +ve means take a long futures contract (even though you're hedging a long position)

Front 25

Hedging Mortgage Securities to Capture Relative Value

Assumptions of 2 bond hedge
(SS10)

Back 25

1. Yield curve shifts in constructing two-bond hedge are reasonable.
2. The prepayment model used does a good job of estimating how the cash flows will change when the yield curve changes
3. Monte Carlo model is good (interest rate volatility assumption is good)
4. Average price change is a good approximation of how the mortgage security's price will change for a small movement in ir.
THIS IS THE ASSUMPTION THAT BREAKS DOWN. (cuspy-coupons)

Front 26

Hedging Mortgage Securities to Capture Relative Value

What to do when you have cuspys?
(SS10)

Back 26

Cuspys are where your aveage price change approximations are way off.
i. Therefore 2-bond hedge is going to give you errors because of the negative convexity of the cuspy-coupon.
ii. USE Two-Bond Hedge + Options
Buying puts and calls eliminates this drift.
Now you are insensitive to any ir movements.
iii. Initial yield advantage from MBS = 11
Cost of the premium to hedge out the cuspiness = 7
Net yield gain = 11 - 7 = 4