1

Investments Analysis
Last 2 Weeks: Fixed Income Securities
Bond Prices and Yields
Term Structure of Interest Rates
Last & this Weeks:
Performance benchmarking
Bond-specific Risks
Interest rate risk
Credit Risk
Part II:
Fixed Income Markets
Interpreting the Yield Curve
TSOIR and interest rate uncertainty
link between
interest rates
liquidity premia
Various cases
possible cases
interpretation
TSOIR & Interest Rate Uncertainty
Interpreting the term structure
Short perspective
liquidity preference theory (investors)
liquidity premium theory (issuer)
Long perspective
Expectations hypothesis
Market Segmentation vs. Preferred Habitat
Examples
TSOIR & Interest Rate Uncertainty 2
Short perspective
liquidity preference theory ( short investors)
investors need to be induced to buy LT securities
example: 1-year zero at 8% vs. 2-year zero at 8.995%
liquidity premium theory (issuer)
issuers prefer to lock in interest rates
f
2
E[r
2
]
f
2
= E[r
2
] + risk premium
TSOIR & Interest Rate Uncertainty 3
Long perspective
long investors wish to lock in rates
roll over a 1-year zero at 8%
or lock in via a 2-year zero at 8.995%
E[r
2
] f
2
f
2
= E[r
2
] - risk premium
Expectation Hypothesis
E[r
2
] = f
2
(risk premium = 0)
idea: arbitrage
2
TSOIR & Interest Rate Uncertainty 4
Market segmentation theory
idea: clienteles (ST and LT bonds are not substitutes)
(un)reasonable?
Preferred Habitat Theory
investors prefer some maturities but can be tempted
In practice
liquidity preference + preferred habitat
these hypotheses are thought more reasonable
TSOIR & Interest Rate Uncertainty 5
Example 1
short term rates: r
1
= r
2
= r
3
= 10%
liquidity premium = constant 1% per year
YTM
% 67 . 10 1 %) 11 1 %)( 11 1 %)( 10 1 ( 1 ) 1 )( 1 )( 1 (
3 3
3 2 1 3
= + + + = + + + = f f r y
% 5 . 10 1 %) 1 % 10 1 %)( 10 1 ( 1 ) 1 )( 1 (
2 1 2
= + + + = + + = f r y
% 10
1 1
= = r y
TSOIR & Interest Rate Uncertainty 6
Example 2: Quick & dirty forward rates
Zero-Coupon Rates Bond Maturity (1yr) Fwd Rate
y
1
= 12.00% 1 f
1
= y
1
= 12%
y
2
= 11.75% 2 f
2
11.5%
y
3
= 11.25% 3 f
3
10.25%
*
y
4
= 10.00% 4 f
4
6.25%
*
y
5
= 9.25% 5 f
5
6.25%
*
*:
If computed exactly, f
3
=10.26%; f
4
=6.33%; f
5
=6.30% (well show this below)
TSOIR & Interest Rate Uncertainty 7
Example 2: Quick expected future short rates
Period (1yr) Fwd Rate Expected short rate
*
1 f
1
= y
1
= 12% N-A
2 f
2
11.5% E(y
1
) = r
2
11%
3 f
3
10.25% E(y
1
) = r
3
9.75%
4 f
4
6.25% E(y
1
) = r
4
5.75%
5 f
5
6.25% E(y
1
) = r
5
5.75%
*: Assumes a constant 0.5% per year liquidity premium
TSOIR & Interest Rate Uncertainty 8
Example 2: Quick expected future bond prices in 2 years
Period Exp. Short Rate Fwd Rate Zero-Coupon Rates
1 N-A N-A N-A
2 N-A N-A N-A
3 E(y
1
) = r
3
9.75% f
1
9.75%
*
y
1
9.75 %
4 E(y
1
) = r
4
5.75% f
2
6.25%
**
y
2
8 %
5 E(y
1
) = r
5
5.75% f
3
6.25%
**
y
3
7.42 %
*:
In two years, this will be the current year > no LP need be added/subtracted
**: Assumes a constant 0.5% per year liquidity premium
TSOIR & Interest Rate Uncertainty 9
Example 2: Formal forward rates
Zero-Coupon Rates Bond Maturity (1yr) Fwd Rate
y
1
= 12.00% 1 f
1
= y
1
= 12%
y
2
= 11.75% 2 f
2
= 11.5%
y
3
= 11.25% 3 f
3
= 10.26%
*
y
4
= 10.00% 4 f
4
= 6.33%
*
y
5
= 9.25% 5 f
5
= 6.30%
*
*:
If computed quickly, f
3
=10.25%; f
4
=6.25%; f
5
=6.25%
3
TSOIR & Interest Rate Uncertainty 10
Example 2: Formal forward rates
1yr Forward Rates
1yr from now : f
2
= [(1.1175)
2
/ 1.12] - 1 = 0.115006
2yrs from now: f
3
= [(1.1125)
3
/ (1.1175)
2
] - 1 = 0.102567
3yrs from now : f
4
= [(1.1)
4
/ (1.1125)
3
] - 1 = 0.063336
4yrs from now : f
5
= [(1.0925)
5
/ (1.1)
4
] - 1 = 0.063008
TSOIR & Interest Rate Uncertainty 11
Example 2: Formal expected future bond prices in 2 years
Period Exp. Short Rate Fwd Rate Zero-Coupon Rates
1 N-A N-A N-A
2 N-A N-A N-A
3 E(y
1
) = r
3
= 9.76% f
1
= 9.76%
*
y
1
= 9.76 %
4 E(y
1
) = r
4
= 5.83% f
2
= 6.33%
**
y
2
= 8.03 %
5 E(y
1
) = r
5
= 5.80% f
3
= 6.30%
**
y
3
= 7.36 %
*:
In two years, this will be the current year > no LP need be added/subtracted
**: Assumes a constant 0.5% per year liquidity premium
TSOIR & Interest Rate Uncertainty 8
Example 2: Quick expected future bond prices in 2 years
Period Exp. Short Rate Fwd Rate Zero-Coupon Rates
1 N-A N-A N-A
2 N-A N-A N-A
3 E(y
1
) = r
3
9.75% f
1
9.75%
*
y
1
9.75 %
4 E(y
1
) = r
4
5.75% f
2
6.25%
**
y
2
8.00 %
5 E(y
1
) = r
5
5.75% f
3
6.25%
**
y
3
7.42 %
*:
In two years, this will be the current year > no LP need be added/subtracted
**: Assumes a constant 0.5% per year liquidity premium
Interpreting the TSOIR
Types of yield curve
cases
upward sloping (most common)
downward sloping
hump-shaped
Fig 15.1
Interpretative assumptions
either short rates are the culprit
or the liquidity premium is positive
Interpretation 2: Rising yield curves
Causes
either short rates are expected to climb: E[r
n
] E[r
n-1
]
or the liquidity premium is positive
Fig. 15.1B
Interpretative assumptions
estimate the liquidity premium
assume the liquidity premium is constant
empirical evidence
liquidity premium is not constant; past > future?!
Interpretation 3: Inverted yield curve
Easy interpretation
if there is a liquidity premium
then inversion expectations of falling short rates
why would interest rates fall?
inflation vs. real rates
inverted curve recession?
Example
2000 yield curve
4
Interpretation 4: Hump-Shape curve
Interpretation
liquidity?
Example
Spring 00 yield curve
Arbitrage Strategies
Question:
The YTM on 1-year-maturity zero coupon bonds is 5%
The YTM on 2-year-maturity zero coupon bonds is 6%.
The YTM on 2-year-maturity coupon bonds with coupon rates of 12% (paid annually) is
5.8%.
What arbitrage opportunity exists for an investment banking firm? What is the arbitrage
profit?
Arbitrage Strategies
Answer:
The price of the coupon bond, based on its YTM, is:
120 PA(5.8%, 2) + 1000 PF(5.8%, 2) = $1,113.99.
If the coupons were stripped and sold separately as zeros, then based on the YTM of
zeros with maturities of one and two years, the coupon payments could be sold separately
for
[120/1.05] + [1,120/1.06
2
] = $1,111.08.
The arbitrage strategy is to:
buy zeros with face values of $120 and $1,120 and respective maturities of 1 and
2 years
simultaneously sell the coupon bond.
The profit equals $2.91 on each bond.
Fixed Income Portfolio Management
In general, bonds are just securities > CAPM
Specific issues:
Benchmarking bond-fund managers performance
Bond indices & Cellular approach (NOT Exam Material )
Risk
Cash-flow risk (incl. default risk)
Not Exam Material
Interest rate risk: Measurement + Management
Bond Index Funds NOT Exam Matl
Idea
Similar to that behind stock market indices
Problem & Solution
Cellular approach
Bond Index Funds 2 NOT Exam Matl
US indices for investment-grade, 1+ year bonds:
BIG= Citigroup/Solomon Smith Barney Broad Investment Grade
treasuries, agency debt, corporates, 144As, mortgage-backed securities (MBS),
and asset-backed securities (ABS)
The AGG = Lehman U.S. Aggregate Bond
Same + municipals and commercial mortgage-backed securities (CMBS)
Merrill Lynch
Domestic Master (Ticker D0A0): U.S. gvt & corporate public bonds
U.S. Broad Market: also includes MBS, global bonds, Yankee bonds, but
excludes ABS, tax -exempt munis, etc.
None of those indices include TIPS
5
Bond Index Funds 3 NOT Exam Matl
Problems
Lots of securities in each index
4 to 5,000 bonds
difficult to buy all the bonds
Portfolio rebalancing
market liquidity
bonds are dropped (maturities, calls, defaults, )
Bond Index Funds 4 NOT Exam Matl
Solution:
cellular approach (Fig. 16.9)
idea
classify by maturity/risk/category/
compute percentages in each cell
match portfolio weights
effectiveness
average absolute tracking error = 2 to 16 b.p. / month
Bond Index Funds 5 NOT Exam Matl
Cellular approach (Fig. 16.9)
Special risks for bond portfolios
Cash-flow risk
call, default, sinking funds, early repayments,
solution: select high quality bonds
Interest rate risk
bond prices are sensitive to YTM
solution
measure interest rate risk
immunize
Interest Rate Risk
Equation:
P =
Yield sensitivity of Prices:
P yield
Measure?
) 1 ( ) 1 ( 1 r
Par
r
coupon
T
T
t
t
+
+
+

=
Interest Rate Risk 2
Determinants of a bonds yield sensitivity
6
Interest Rate Risk 3
Determinants of a bonds yield sensitivity
Interest Rate Risk 4
Determinants of a bonds yield sensitivity
time to maturity
maturity sensitivity (concave function)
coupon rate
coupon sensitivity
discount bond vs. premium bond
zeroes have the highest sensitivity
intuition: coupon bonds = average of zeroes
YTM
initial YTM sensitivity
Duration
Idea
maturity sensitivity
to measure a bonds yield sensitivity,
measure its effective maturity
Measure
Macaulay duration:
1
) 1 (
1
1 1
= =
+
=

= = P
P
YTM
C
P
w
T
t
t
t
T
t
t
) 1 .( YTM P
C
w
t
t
t
+
=
t
T
t
w t D .
1

=
=
Duration 2
Duration = effective measure of elasticity
Proof
Modified duration
with

+
+
=

YTM
YTM
D
P
P
1
) 1 (
.
[ ] YTM D
P
P
=

.
*
y
D
D
+
=
1
*
Duration 3
Interpretation 1
= average time until bond payment
Price risk & reinvestment risk offset if bond sold at D
Interpretation 2
% price change of coupon bond of a given duration
= % price change of zero with maturity = to duration
t
T
t
w t D .
1

=
=
Duration 4
Example
bond: 2-year, 10% ytm, 8% coupon, annual payments
8%
Bond
Time
years
Payment PV of CF
(10%)
Weight Col.1
times Col.4
72.73 = 80/1.10 1 80 0.0753
= 72.73 / 965.29
0.0753
2 1080
sum
892.56
965.29
0.9247
1.000
1.8494
1.9247
7
Duration 5
Example (Continued)
suppose YTM changes by 1 basis point (0.01%)
either compare the bonds price with YTM = 10.01%
relative to the bonds price with YTM = 10%
or simply compute the price change from the duration
% 0175 . 0
10 . 1
% 10 % 01 . 10
x 9247 . 1
1
) 1 (
. =

+
+
=

YTM
YTM
D
P
P
Duration 6
Example (Spreadsheet 16.1)
1
st
bond: zero coupon with 1.8853 years to maturity
2
nd
bond: 2-year, 10% ytm, 8% coupon, semi-annual
8%
Bond
Time
years
Payment PV of CF
(10%)
Weight Col.1
times Col.4
0.5 40 38.095 = 40 / 1.05 0.0395 0.0197
1 40 36.281 0.0376
= 36.281 / 964.54
0.0376
1.5
2.0
40
1040
sum
34.553
855.611
964.540
0.0358
0.8871
1.000
0.0537
1.7742
1.8852
Duration 7
Example (Continued, Spreadsheet 16.1)
suppose YTM changes by 1 basis point (0.01%)
zero coupon bond with 1.8853 years to maturity
old price
new price
( )
9623 . 831
05 . 1
1000
7706 . 3
= =
( )
6636 . 831
0501 . 1
1000
7706 . 3
= =

+
+
= =

YTM
YTM
D
P
P
1
) 1 (
. % 0359 . 0
9623 . 831
9623 . 831 6636 . 831
Duration 8
Example: (Continued, Spreadsheet 16.1)
suppose YTM changes by 1 basis point (0.01%)
2-year, 8% coupon bond
either compare the bonds price with YTM = 5.01%
relative to the bonds price with YTM = 5%
or simply compute the price change from the duration
% 0359 . 0
05 . 1
% 5 % 01 . 5
x 2 x 8853 . 1
1
) 1 (
. =

+
+
=

YTM
YTM
D
P
P
Duration 9
Properties of duration (other things constant)
zero coupon bond: duration = maturity
time to maturity
maturity duration
exception: deep discount bonds (e.g., 3% bond, Fig. 16.3)
coupon rate
coupon duration
YTM
YTM duration
exception: zeroes (unchanged)
Duration 10
Properties of duration Illustration (Fig. 16.3)
8
Duration 11
Formulae for duration
duration of perpetuity =
less than infinity!
coupon bonds ( annuities + zero)
see book
simplifies if par bond
y
y
D
+
=
1
Duration 12
Importance
simple measure
essential to implement portfolio immunization
measures interest rate sensitivity effectively
Possible Caveats to Duration
1. Assumptions on term structure
Macaulay duration uses YTM
only valid for level changes in flat term structure
Fisher-Weil duration measure (NOT exam material)

=
=
=
+
= =
T
t
t
s
s
t
T
t
t
r
C
t
P
w t D
1
1
1
) 1 (
.
1
.

= =
+
= =
T
t
t
t
T
t
t
YTM
C
t
P
w t D
1 1
) 1 (
.
1
.
Possible Caveats to Duration 2
problems with the Fisher-Weil duration
assumes a parallel shift in term structure
need forecast of future interest rates
bottom line: same issue as for realized compound yield
Cox-Ingersoll-Ross duration (NOT exam material)
Conclusion: lets keep Macaulay
Possible Caveats to Duration 3
2. Convexity
Macaulay duration
first-order approximation:
small changes vs. large changes
duration = point estimate
for larger changes, an arc estimate is needed
solution: add convexity
) 1 ( .
*
YTM D
P
P
+ =

Possible Caveats to Duration 4

9
Possible Caveats to Duration 5
Convexity (continued)
second-order approximation:
( )
2 *
. .
2
1
. YTM convexity YTM D
P
P
+ =

=
+
+
+
=
T
t
t
t
YTM
C
t t
YTM P
convexity
1
2
2
) 1 (
). (
) 1 (
1
Possible Caveats to Duration 6
Convexity: numerical example
P = Par = 1,000; T = 30 years; 8% annual coupon
computations give D*=11.26 years; convexity = 212.4 years
suppose YTM = 8% > YTM = 10%
% 52 . 22 02 . 0 26 . 11 .
*
= = =

x YTM D
P
P
( ) % 27 . 18 . .
2
1
.
2 *
= + =

YTM convexity YTM D

P
P
% 85 . 18
000 , 1
000 , 1 46 . 811
=

P
P
Possible Caveats to Duration 7
Is convexity priced?
Attractive > bond A more expensive than B (why?)
Possible Caveats to Duration 8
Convexity for callable bonds
Possible Caveats to Duration 9
Convexity for MBS
Bottom Line on Duration
Very useful
But take it with a grain of salt for large changes
10
Immunization
Why?
obligation to meet promises (pension funds)
protect future value of portfolio
ratios, regulation, solvency (banks)
protect current net worth of institution
How?
measure interest rate risk: duration
match duration of elements to be immunized
Immunization
What?
net worth immunization
match duration of assets and liabilities
target date immunization
match inflows and outflows, immunize the net flows
match duration to holding period
Who?
banks
net worth immunization
insurance companies, pension funds
target date immunization
Net Worth Immunization
Gap management
assets vs. liabilities
long term (mortgages, loans, ) vs. short term (deposits, )
match duration of assets and liabilities
decrease duration of assets (ex.: ARM)
increase duration of liabilities (ex.: term deposits)
condition for success
portfolio duration = 0 (assets = liabilities)
Target Date Immunization
Idea:
Price risk & reinvestment risk offset if bond is sold at D
Example for intuition: Suppose interest rates fall
good for the pension fund
price risk
existing (fixed rate) assets increase in value
bad for the pension fund
reinvestment risk
PV of future liabilities increases
so more must be invested now
Target Date Immunization 2
Idea: Invest in assets with D matching the funds
investment horizon, so that yields dont affect the FV
Implementing this solution/idea
match duration of portfolio and funds horizon
single bond
bond portfolio
duration of portfolio
= weighted average of components duration
condition: assets have equal yields
11
Target Date Immunization 3
Question:
Pension funds pay lifetime annuities to recipients.
Firm expects to be in business indefinitely, its pension obligation perpetuity.
Suppose, your pension fund must make perpetual payments of $2 million/year.
The yield to maturity on all bonds is 16%.
(a) duration of 5-year bonds with coupon rates of 12% (paid annually) is 4 years
duration of 20-year bonds with coupon rates of 6% (paid annually) is 11 years
how much of each of these coupon bonds (in market value) should you hold to both
fully fund and immunize your obligation?
(b) What will be the par value of your holdings in the 20-year coupon bond?
Target Date Immunization 4
Answer:
(a) PV of the firms perpetual obligation = ($2 million/0.16) = $12.5 million.
duration of this obligation = duration of a perpetuity = (1.16/0.16) = 7.25 years.
Denote by w the weight on the 5-year maturity bond, which has duration of 4 years.
Then,
wx 4 + (1 w) x 11 = 7.25, which implies that w= 0.5357. Therefore,
0.5357 x $12.5 = $6.7 million in the 5-year bond and
0.4643 x $12.5 = $5.8 million in the 20-year bond.
The total invested = $(6.7+5.8) million = $12.5 million, fully matching the funding
needs.
Target Date Immunization 5
Answer:
( b ) Price of the 20-year bond = 60 x PA(16%, 20) + 1000 x PF(16%, 20) = $407.11.
Therefore, the bond sells for 0.4071 times Par, and
Market value = Par value x 0.4071
=> $5.8 million = Par value x 0.4071
=> Par value = $14.25 million.
Another way to see this is to note that each bond with a par value of $1,000 sells for
$407.11. If the total market value is $5.8 million, then you need to buy 14,250 bonds,
which results in total par value of $14,250,000.
Dangers with Immunization
1. Portfolio rebalancing is needed
Time passes duration changes
bonds mature, sinking funds,
YTM changes duration changes
example: BKM7 Table 16.4
duration YTM
5 8%
4.97 7%
5.02 9%
Dangers with Immunization 2
2. Duration = nominal concept
immunization only for nominal liabilities
counter example
childrens tuition
why?
solution
do not immunize
buy assets
An Alternative? Cash-Flow Dedication
Buy zeroes
to match all liabilities
Problems
difficult to get underpriced zeroes
zeroes not available for all maturities
example: perpetuity
12
Contingent Immunization
Idea
try to beat the market
while limiting the downside risk
Procedure (Fig. 16.12) NOT Exam Material
compute the PV of the obligation at current rates
assess available funds
play the difference
immunize if trigger point is hit
Contingent Immunization 2
Procedure (Fig. 16.12)