CHAPTER19

FIXEDINCOMEPORTFOLIOMANAGEMENT

AlternativeBondPortfolioStrategies
PassiveBondPortfolioStrategies
BuyandHoldStrategy
IndexingStrategy
ActiveManagementStrategies
InterestRateAnticipation
Ladderstrategy
Barbellstrategy
ValuationAnalysis
CreditAnalysis
Analysisofjunkbonds
YieldSpreadAnalysis
BondSwaps
Pureyieldpickupswap
Substitutionswap
Taxswap
Strategiesandmarketefficiency
Bondportfoliostyles
AGlobalFixedIncomeInvestmentStrategy
MatchedFundingTechniques
ImmunizationStrategies
Componentsofinterestraterisk
Pricerisk
Reinvestmentrisk
Classicalimmunizationandinterestraterisk
Aportfolioofbondsisimmunizedfrom
interestrateriskifthedurationofthe
portfolioisalwaysequaltothedesired
investmenthorizon.
Examplesofclassicalimmunization
Maturitystrategy
Durationstrategy
Anotherviewofimmunization
Applicationofclassicalimmunization
DedicatedPortfolios
Purecashmatcheddedicatedportfolio
Dedicationwithreinvestment
Horizonmatching

53

UsingDerivativeSecuritiesinFixedIncomePortfolioManagement
ModifyingPortfolioRiskandReturn:AReview

UsingDerivativesforAssetAllocation
UsingDerivativestoControlPortfolioCashFlows
HedgingPortfolioCashInflows
HedgingPortfolioCashOutflows
TheTreasuryBondFuturesContract
DeterminingHowManyContractstoTradetoHedgea
DepositorWithdrawal
Conversionfactor
Durationadjustmentfactor
DeterminingHowManyContractstoTradetoAdjust
PortfolioDuration
Weightedaveragedurationsapproach

UsingFuturesinPassiveFixedIncomePortfolioManagement
UsingFuturesinActiveFixedIncomePortfolioManagement
ModifyingSystematicRisk
ModifyingUnsystematicRisk
ModifyingtheCharacteristicsofanInternationalBond
Portfolio

54

CHAPTER19
AnswerstoQuestions

1.

Usingapurebuyandholdstrategy,aninvestorwouldbuy
bondswithdesiredcouponlevels,termtomaturity,etc.
and hold them to maturity or the end of his specific
investment horizon. With a modified buyandhold
strategy, the investor has the same intent to hold the
bondstotheendofhisinvestmenthorizon,butheexpects
and seeks opportunities to trade into a more desirable
positionwhentheoccasionarises.

2.

Indexing involves the building of a portfolio that will

matchtheperformanceofaselectedbondmarketindexsuch
as the Lehman Brothers Index, Merrill Lynch Index or
SalomonBrothersIndex.Thebasicjustificationforusing
an indexing strategy is that numerous empirical studies
have shown that the majority of moneymanagers have not
been able to match the riskreturn performance of bond
indexes.

3.

Inapureyieldpickupswap,alowcouponbondissoldand
a comparable highercoupon bond is purchased, thereby
increasingboththecurrentyieldandyieldtomaturity.

Inasubstitutionswap,bondswhichhaveidenticalcoupon
rates, credit ratings, and time to maturity but an
imbalance in shortterm pricing are exchanged. This
imbalanceinpricingbetweenthetwoissuesshouldcorrect
itselfwithinashortperiodoftime,unlessthereisa
realdifferenceinthequalityofthebonds.
Ataxswapisenteredintoasawayofoffsettingrealized
capital gains with capital losses. Tax swaps occur
becauseoftaxregulationsratherthanduetoshorttime
marketanomalies.
4.Thetwoprimaryreasonsforpurchasingdeepdiscounted
bonds are: (1) they provide the opportunity for
substantial capital gains and (2) bond principle is
automaticallyreinvestedasitgrowstowardparvalueat
maturity.
5.

Interest rate anticipation, valuation analysis, credit

analysis, yield spread analysis and bond swaps are all
considered active bond portfolio management strategies.
Interest rate anticipation is the riskiest strategy
becauseitreliesonforecastinguncertainfutureinterest
55

rate behavior. The strategy involves altering the

maturity(duration)structureoftheportfoliotopreserve
capitalwhenanincreaseininterestratesisanticipated
and achieve capital gains when they are expected to
decline. A creditanalysis strategyinvolvesattempting
toprojectchangesinqualityratingsassignedtobonds.
Itisnecessarytoanalyzeinternalchangesinthefirm
andexternalchangesintheenvironmenttoprojectrating
changes prior to the actual announcement by rating
agencies. Yieldspreadanalysis involvesmonitoringthe
yieldrelationshipsbetweenvariousbondsectorstotake
advantageofabnormalrelationshipsbyexecutingvarious
sectorswaps.Liquidityisakeyfactorinthisstrategy,
as abnormal relationships are only believed to be
temporary.
6.

Twoimportantvariableswhenanalyzingjunkbondsinclude:
(1) the use of cash flows in relation to debit
obligations, and (2) a detailed analysis of potential
asset sales. The cash flow analysis is important in
determiningthefirm'sabilitytomakeinterestpayments,
as well as maintain cash for research and growth in
periodsofeconomicdecline. Cashflowcanalsoaffect
thefirm'sborrowingcapacitytoprovideflexibilityand
neededworkingcapital.Inmanycases,assetsalesarea
criticalpartofthestrategyforaleveragedbuyout.In
ordertoanalyzethemarketvalueoftheseassetsitis
necessarytodeterminewhetherthereareanypriorliens
againsttheassets,aswellasthetrueliquidationvalue
andareasonabletimeperiodforthesale.

7.

Theadvantageofthecashmatchedportfolioisthatitis
a relatively conservative strategy in which cash flows
generatedfromtheportfolioaredesignedtoexactlymatch
liability schedules in both timing and amount. Such a
portfolioisoftendifficulttoconstructasaresultof
certain call features often associated with the higher
yieldingdeepdiscountbonds. Ontheotherhand,ifthe
portfoliomanagerlimitshimselftoonlyTreasurybonds,
hewilllikelyforegosignificantaddedreturnsthatcould
beachievedwithotherinvestments,thusaddingtothenet
costoffundingtheliabilitystream.

8.

Interestrateriskcomprisestworisksapriceriskanda
coupon reinvestment risk. Price risk represents the
changethatinterestrateswilldifferfromtheratesthe
manager expects to prevail between purchase and target
date.Suchachangecausesthemarketpriceforthebond
(i.e., the realized price) to differ from the expected
price. Obviously, if interest rates increase, the
realizedpriceforthebondinthesecondarymarketwill
56

be below expectations, while if interest rates decline,

therealizedpricewillexceedexpectations.
Reinvestmentriskarisesbecauseinterestratesatwhich
coupon payments can be reinvested are unknown. If
interestrateschangeafterthebondispurchased,coupon
paymentswillbereinvestedatratesdifferentthanthat
prevailingatthetimeofthepurchase.Asanexample,if
interestratesdecline,couponpaymentswillbereinvested
at lower rates than at the time of purchase and their
contributiontotheendingwealthpositionoftheinvestor
will be below expectations. Alternatively, if interest
ratesincrease,therewillbeapositiveimpactascoupon
paymentswillbereinvestedatratesaboveexpectations.
9.

A portfolio of investments in bonds is immunized for a

holdingperiodifthevalueoftheportfolioatthetime
and the holding period, regardless of the course of
interestratesduringtheholdingperiod,isatleastas
largeasitwouldhavebeenhadtheinterestratefunction
beenconstantthroughouttheholdingperiod.Putanother
way,iftherealizedreturnonaninvestmentinbondsis
suretobeatleastaslargeasthecomputedyieldtothe
investmenthorizon,thenthatinvestmentisimmunized.As
anexample,ifaninvestoracquiredaportfoliobondwhen
prevailinginterestrateswere10%andhadaninvestment
horizonoffouryears,thentheinvestorwouldexpectthe
beginningvalue. Thisparticularvalueisequalto10%
compoundedforfouryears.
Abondmanagerwouldwanttoimmunizetheportfoliointhe
instancewherehe/shehadaspecifiedinvestmenthorizon
andhadadefiniterequiredorpromisedyieldforthebond
portfolio. Inthecasewherethisrequiredorexpected
yieldwasbelowcurrentprevailingmarketrates,itwould
be worthwhile for the bond managers to immunize the
portfolio and therefore "lock in" the prevailing market
yieldforthisperiod. Putanotherway,itiswhenthe
bondportfoliomanageriswillingtoengageinnonactive
bond portfolio management and accept the current
prevailingrateduringtheinvestmenthorizon.

10.

Asmentioned,thepurposeofimmunizationistomitigate
the price risk and reinvestment risk associated with
changes in interest rates over the investment horizon.
Assumingaflatyieldcurveovertheinvestmenthorizon,
thereisnoneedtoimmunizetheportfolio.Theinvestor
canobtaininvestmentobjectivesbysimplypurchasing

57

bondsscheduledtomatureattheendofhisinvestmenthorizon.
With no change in interest rates, the stated yieldto
maturityatthetimeofpurchaseshouldequaltherealized
yieldatthetimethebondsmature.
11.

Investmenthorizonayearlater=3
Durationofportfolioayearlater=3.2
While the termtomaturity has declined by a year, the
durationhasonlydeclinedby.8years.Thismeansthat,
assumingnochangesinmarketrates,theportfoliomanager
mustrebalancetheportfoliotoreduceitsdurationto3
years.

12.

The objective of immunization centers around mitigating

thetwocomponentsofinterestrateriskpriceriskand
couponreinvestmentrisk.Keepingthisinmind,manyfeel
thatazerocouponbondistheidealfinancialinstrument
touseforimmunizationbecauseiteliminatestheserisks,
andthuseliminatestheneedtorebalancetheportfolio.
Reinvestmentriskiseliminatedbecauseitisassumedthe
valueofthebondwillgrowatthestateddiscountrate,
and price risk is eliminated because if you set the
durationequaltoyourtimehorizon,youwillreceivethe
facevalueofyourbondatmaturity.

13.

Severalcharacteristicsofdurationmakeitimpossibleto
set a duration equal to the initial time horizon of a
portfolio and ignore it thereafter. First, because
durationdeclinesmoreslowlythantermtomaturity,even
ifoneassumesnochangesininterestrates,theportfolio
manager must periodically rebalance the portfolio.
Second,ifthereisachangeinmarketrates,theduration
oftheportfoliowillchange. Ifthedeviationbecomes
largecomparedtooriginaldurationoftheportfolio,the
manager will again have to rebalance. Third, the
techniqueassumesthatwhenmarketrateschange,theywill
change by the same amount and in the same direction.
Sincethisisnottrueoftherealworld,themanagermust
assure that the portfolio is composed of various bonds
withdurationsthatbuncharoundthedesireddurationof
theportfolio.Finally,developingtheportfoliocanbea
problemsincetherecanalwaysbeaproblemofacquiring
thedesiredbondsinthemarket.

14.

CFAExamIII(June1983)

14(a). Interestrateriskcomprisestworisksapriceriskanda
coupon reinvestment risk. Price risk represents the
chancethatinterestrateswilldifferfromtheratesthe
manager expects to prevail between purchase and target
date.Suchachangecausesthemarketpriceforthebond
58

(i.e., the realized price) to differ from the expected

price. Obviously, if interest rates increase, the
realizedpriceforthebondinthesecondarymarketwill
be below expectations, while if interest rates decline,
therealizedpricewillexceedexpectations.
Reinvestmentrisk arisesbecauseinterestratesatwhich
coupon payments can be reinvested are unknown. If
interestrateschangeafterthebondispurchased,coupon
paymentswillbereinvestedatratesdifferentthanthat
prevailingatthetimeofthepurchase.Asanexample,it
ifinterestratesdecline,couponpaymentswillberein
vested at lower rates than at the time of purchase and
their contribution to the ending wealth position of the
investor will be below expectations. Contrariwise, if
interestratesincreasetherewillbeapositiveimpactas
coupon payments will be reinvested at rates above
expectations.
14(b). A portfolio of investments in bonds is immunized for a
holdingperiodifthevalueoftheportfolioattheendof
theholdingperiod,regardlessofthecourseofinterest
ratesduringtheholdingperiod,isatleastaslargeas
it would have been had the interest rate function been
constantthroughouttheholdingperiod.Putanotherway,
iftherealizedreturnonaninvestmentinbondsissure
to be at least as large as the computed yield to the
investmenthorizon,thenthatinvestmentisimmunized.As
anexample,ifaninvestoracquiredaportfoliobondwhen
prevailinginterestrateswere10%andhadaninvestment
horizonoffouryears,thentheinvestorwouldexpectthe
value of the portfolio at the end of four years to be
1.4641xthebeginningvalue. Thisparticularvalueis
equalto10%compoundedforfouryears.
Abondmanagerwouldwanttoimmunizetheportfoliointhe
instancewherehe/shehadaspecifiedinvestmenthorizon
andhadadefiniterequiredorpromisedyieldforthebond
portfolio. Inthecasewherethisrequiredorexpected
yieldwasbelowcurrentprevailingmarketrates,itwould
beworthwhileforthebondmanagerstoimmunizetheport
folioandtherefore"lockin"theprevailingmarketyield
for this period. Put another way, it is when the bond
portfoliomanageriswillingtoengageinnonactivebond
portfolio management and accept the current prevailing
rateduringtheinvestmenthorizon.

59

14(c). Assetforthbyanumberofauthors,thetechniqueusedto
immunizeaportfolioistosetthedurationoftheport
folioequaltotheinvestmenthorizonfortheportfolio.
Ithasbeenproventhatthistechniquewillworkbecause
duringthelifeoftheportfolio,thetwomajorinterest
raterisks(priceriskandreinvestmentrisk)offseteach
otheratthispointintime.Thezerocouponbondisan
idealimmunizationinstrumentbecause,byitsverynature,
it accomplishes these two purposes when the maturity of
thezerocouponbondequalstheinvestmenthorizonbecause
the duration of a zero coupon bond is equal to its
maturityperiod.Incontrast,whenyoumatchmaturityof
thebondtotheinvestmenthorizon,youareonlytaking
accountofthepriceriskwherebyyouwillreceivethepar
value of the bond at the maturity of the bond. The
problem is that you are not sure of how the investment
riskwillworkout. Itobviouslycanbethatratesrise
inwhichcaseyouwillreceivemoreinreinvestmentthan
expected. Alternatively,ifratesdecline,youwillnot
benefitfromthepriceadvantageand,infact,willlose
intermsofthereinvestmentassumptions.
14(d). Thezerocouponbondisasuperiorimmunizationsecurity
becauseiteliminatesbothinterestrateriskspriceand
reinvestment.
A zero coupon bond is a perfect immunizer when its
duration(ormaturity,astheyarethesame)isequalto
theliabilityorplanninghorizonoftheportfolio.Given
adequateavailability,theportfoliomanagerwouldmatch
theseelementsandnofurtheractivityisnecessarytothe
endofthehorizon.
The zero coupon bond is superior to a coupon paying
instrumentbecausethelackofcashflowpriortomaturity
eliminates any coupon reinvestment and, therefore, the
risk of realized return changes due to uncertainty of
theselevels. Priceriskisalsononexistentregardless
ofthetimingornatureofyieldcurveshifts.
15.CFAExamIII(June1988)
Restructuring opportunities are not a function of time,
but rather a result of changing market conditions.
Conditionsthataregenerallyfavorabletorestructuring
include:
(1)Availabilityofmoreefficientissues.Whenyou
originallystructuredtheportfolioprogram,youused
the issues that were available. Over time, more
issuesbecomeavailablethroughtradingornewissues
60

come to market that do a better job of fitting the

requirementsoftheportfolio. Asaresult,youcan
substituteissuesthatdoabetterjob(i.e.,aremore
efficient)ofmeetingthegoalsoftheportfolio.
(2)Changesintheshapeoftheyieldcurve.Iftheyield
curve changes (e.g., goes from positively sloped to
negative),itmightbepossibletoshiftoutofapure
cashmatchedpolicytoonewhereyoureceivethecash
flowsearlierandcaninvestthematahigherrateof
returntoexceedexpectations.Thequestionbecomes:
Whatwastheassumedreinvestmentratecomparedtothe
currentrates,giventheprevailingyieldcurve?
(3)Changesinqualityorsectorspreads.Thiswould
involve changes in the price relationship between
qualitygroups(e.g.,agenciesversusTreasuries,AAA
versus AA) or sectors (e.g., industrials versus
utilities).Youcouldenvisionaninstancewherethe
yieldspreadofAAAcorporatestotreasuriesthatwere
in the portfolio declined and the spread for FNMA
issueincreasedwhichwouldallowyoutoswaptheAAA
corporatefortheFNMAissue.Thisswapwouldprovide
aportfolioofequalqualityandprobablyallacash
takeout.
16.

CFAExamIII(June1988)

16(a). Youwouldgenerallyexpectittobeeasiertomatchthe
performanceofabondindexascontrastedtoastockindex
because of the aggregate homogeneity of the bond market
comparedtothestockmarket.Asaresultyoucouldmatch
theperformanceofthebondindexwithsubstantiallyfewer
issues.Asanexample,inordertomatchtheperformance
oftheS&P500StockIndex,itgenerallyrequiresanywhere
from 300 to 450 issues. In contrast, one could do a
fairly good job of tracking a bond index that would
include thousands of issues with less than 100 bonds
simply because bonds are so heavily influenced by the
generalmovementsininterestrates.Therefore,although
you might need bonds with different characteristics to
match the index (e.g., industry and quality
characteristics), it would not be necessary to have
numerousissueswitheachofthedesiredcharacteristics.
16(b). Whileitmightbepossibletomatchthebondindexwith
fewer issues, the selection and operational process of
runningthebondindexfundwouldbemoredifficult.

61

(1)First,itisgoingtorequiremorecharacteristicsto
derivethedesireddiversification.Whiletheequity
marketonlyrequiresseriousconsiderationofcapita
lization and risk docile, bonds have many
characteristics that can effect return including
maturity, duration, credit quality, capitalization,
coupon,industrialclassification,sinkingfund,anda
call features. Thus, it will be necessary to
determinethemakeupforeachofthesecharacteristics
andattempttomatchitintheportfolio.
(2)Asecondfactorwouldbethedifficultyoftrading
bondsasopposedtostocks. Inthecaseofastock
index you are typically dealing with very large
capitalization stocks traded on an exchange or
involved in an active overthecounter market. In
contrast,thesecondarycorporatebondmarketisnot
nearly as liquid and so it is difficult to buy and
sellforthebondindexfund.
(3)Finally,thereisgreaterdifficultyinreinvestment
ofthecashflowsfromabondindexfundratherthana
stock index. Because of heavier cash flows from a
bondindexfundyouaregoingtohavemorefrequent
buyingprograms. Thesecanbeablessingbecauseit
allowsyoutochangethemakeupofthefund,butalso
itcouldbedifficulttoavoidchangingthefundwith
smallbuyingprograms. Thepointis,itisgoingto
require balancing cash flow purchases among all
relevant bond characteristics to avoid changing the
bondindexfundportfolio.
17.CFAExamIII(June1986)adapted
With an immunized portfolio the goal is to provide a
minimumdollaramountofassetsatasinglehorizon.
The purpose of a cashmatched dedicated portfolio is to
have a portfolio which will generate cash flows that
specificallymatchtherequired stream ofcashoutflows.
Therefore,itisnecessarytomatchmaturitiesandamounts
overatimeperiod, notasingletimeperiod. Thisis
accomplishedbyplanningmaturitiesandinterimcashflows
fromtheportfolio.
Thepurposeofadurationmatcheddedicationportfoliois
likewisetomatchthecashflowsfromtheportfoliotothe
requiredcashoutflowsovertime.Themajordifference

62

from the cashmatched dedication is that you recognize

thatyoudothisbymatchingtheweightedaverageduration
of the obligations with the duration of your investment
portfolio.
17(b).Whenmanagingan immunized portfolio,itisnecessaryto
maintain the duration of the portfolio equal to the
investment horizon. The problem is that this requires
rebalancingbecause(1)durationdeclinesslowerthanterm
tomaturity,and(2)durationisaffectedbychangesin
market yields i.e., there is an inverse relationship
betweenyieldandduration.

17(c).Withacashmatcheddedicationportfolioitisnecessary
tomakeseveralmajordecisions.
(1)Timingofinitiation.Usually,theclientwantsto
initiatetheportfolioimmediately.Lettheclient
prevailunlesstheportfoliomanagerconsidersadelay
advisable.
(2)Paymentstimeintervals.Specifywhentherequired
paymentsaretobemadeyearly,semiannually,
quarterly.
(3)Howtoavoidcallrisk.Isthisaccomplishedby
havingdeepdiscountbondsornoncallablesecurities?
(4)Whatisyourreinvestmentrateassumptionforthe
interimflows?Youshouldbeveryconservativein
yourestimatetoavoidnegativesurprises.
17(d).Oncetheportfolioisestablished,thecashmatcheddedi
cated portfolio probably requires the least supervision
over time. You do not have to rebalance the immunized
portfoliooradjustthedurationofthedurationmatched
dedicatedportfolio.
18.Futureshaveasymmetricalimpactonportfolioreturns
(SeeFigure20.4).Buyingfutureswidensthereturndis
tribution,therebyshowingalargerreturnvariance. In
contrast,sellingfutureshastheeffectofdecreasingthe
returnvariance.
Options do not have a symmetical impact on portfolio
returns(SeeFigure20.5).Forexample,(1)downsiderisk
iscontrolledbybuyingaputoptionwhenyouarelongin
thesecurityor(2)upsidereturnislimitedbywritinga
coveredcall.

63

19.Initially,futurescouldbepurchasedwiththeportfolio
cashinflowsresultinginlowercommissionsandlessprice
impactthanpurchasingthebondissuesoutright.Thecash
inflows are thus invested, allowing the manager time to
consider which bonds should be purchased. Futures
contractsaresubsequentlysoldinordertoprovidefunds
forthebondpurchases.
Assecuritiesaresold,cashisgenerated.Thiscashcould
be invested in futures, thereby maintaining the port
folio'soverallexposuretobondswhileaccumulatingcash.
20.Inabondportfolio,systematicormarketriskarisesfrom
thesensitivityoftheportfolio'svaluetointerestrate
changes. Theconceptofdurationprovidesameasurement
ofthesensitivitylevel.Unsystematicriskistheunique
riskassociatedwithaparticularasset.Unlikeanequity
portfolio, there are only a few opportunities for
controllingunsystematicriskinabondportfolio.There
areonlyasmallnumberoffuturesandoptioncontracts
available (i.e., Treasury issues, mortgagebacked
securities and municipal bonds). By buying or selling
futures or option contracts, a manager is ability to
quickly and for less cost adjust the bond portfolio
allocation in light of systematic and unsystematic risk
exposure.

21.Currencyfuturesandoptionsoncurrencyfuturescanbe
boughtorsoldinorderadjustthecurrencyexposureof
theinternationalbondportfolio.
22.CFAExaminationII(1996)
A.Thesignificanceistoshowthe downwardslope ofthe
yieldcurveinthefirstyear,coincidingwiththe50bp
changeinsixmonthsand50bpinoneyear.

Discussion
Theyieldcurveissteeplyinverted(downwardsloping),at
leasttothefirstyeartoreflectthetwo50bpadjust
ments,thenbecomesslightlyinvertedthroughthe21/2
yearmark,andisbasicallyflatbythreeyears.

64

B. The shape of the yield curve is explained by the

Expectations Theory or the Liquidity Preference Theory.
ExpectationsTheorypostulatesthattheshapeoftheterm
structure is determined by market participants'
expectations of future interest rates, which allow the
accuratepredictionoffuturespotratesfromthecurrent
termstructure.

TheLiquidityPreferenceTheorypostulatesthatwhatever
riskaverse investors' expectations are about rates,
because they prefer to hold shortterm maturity bonds,
they require a yield premium to buy longer term bonds.
When the market anticipates lower rates, the liquidity
premiumwilldampenthedownwardslopeoftheyieldcurve.

Alternative approach to the answer: Spot rates are a

geometric average of forward rates. When rates are
expectedtofall,investorswillrequirehigheryieldsto
hold shorter maturities (because of the lower yields
expected when the short maturities must be reinvested),
andthetermstructurewillslopedownward.Thesmallterm
premiumswillmodifytheslopeofthecurvebutarenot
enoughtomaketheshapeofthecurveupwardslopingin
theearlyyears.

Forwardratesandspotratesarerelatedaccordingtothe
followingformula:

(1+Rt)t=(1+Rtj)tj(1+fj,tj)j

UndertheLiquidityPreferenceTheory,therelationship
betweenspotandforwardratesissomewhatdifferent:

(1+Rt)t=(1+Rtj)tj[1+E(Rj,tj)+L]j
C. Assume that the expected 50 bp declines in Federal
Funds rates in 6 and 12 months are both delayed by 6
monthsandthattheFederalFundsrateisnowexpectedto
increaseby100bpin21/2years(whennoincreasewas
previouslyexpected).

If you agree with the new interest rate forecast, you

should select the twoyear benchmark U.S. Treasury
(bullet) instead of the cash/threeyear U.S. Treasury
barbell.

The delayed 50 bp drops in future rates and the 100 bp

increase both cause current cash or spot rates to
increase, implying an upward shift of the yield curve,
whichwilloccurintwoweeks.Bothinvestmentshavethe
65

same duration, but the barbell, which has the greater

convexity,mightbeexpectedtohavethesmallerdecline
invalueintwoweekswhenthemarketsharesyourview.
However, the yield curve shift is nonparallel. A
steepening occurs, where the threeyear rate increases
morethanthetwoyearrate.Suchasteepeningincreases
the value of a bullet relative to a barbell. In this
example, the steepening is sufficient for the bullet to
experiencealowerdeclineinvaluethanthebarbell.

Alternative justification. Given the new expectations

about future interest rates, the twoyear interest rate
willincreaseapproximately25bpandthethreeyearrate
willincreaseapproximately33bp.GivenprevailingU.S.
Treasury rates, increases of this size will cause the
threeyearTreasurytodeclinemuchmorethanthetwoyear
(thethreeyearfallsroughlytwiceasmuch).Eventhough
thebarbellinvestsonlyabouttwothirdsofitsvaluein
the dimeyear (and the rest in cash), the total dollar
declineinthebarbellwillbemorethanthetotaldollar
declineinthetwoyearbullet.
23.CFAExaminationLevelII(1997)

A.WhatLaneShouldDo
Toprotecthisinvestmentfromdeclininginterestrates,
MikeLaneshouldpurchase,or"golong,"$5millionworth
ofU.S.Treasuryfiveyearnotefuturescontracts. Lane
can actually purchase any of the traded fiveyearnote
futures contracts, depending on what date he actually
planstoinvesthis$5million.

B.EffectofHigherInterestRatesonLane'sPosition
Ifratesincreaseby100basispointsinthreemonths,the
price of these futures contracts will decline and Lane
willhavealossinhislongfuturesposition.Theloss
willshowupinhismarktomarketpositionovertimeand
willrequirehimtopostadditionalmarginmoney.
C.ReturnfromLane'sHedgedPositionvs.UnhedgedReturn
TwomethodscanbeusedtoanswerPartC.

OneansweristhatthereturnfromLane'shedgedposition
will be lower than the return if he had not hedged.
Because of the futures contract's loss in Part B, the
higheryieldLanecanearnwhenhepurchasesanowlower
priced(higheryield)U.S.Treasuryfiveyearnoteinthe
cash market is "offset" by the loss from the futures
contract. The loss is actually added to the now lower
66

price of the U.S. Treasury fiveyear notes, thus

decreasingLane'srealizedyield.

AsecondanswerdrawsfromtheClarkereading.Thereading
expressesthecombinedfuturescontract'spriceandcash
marketpriceintermsof"netprice." Netpriceequals
thenewcashmarketpriceplustheoriginalfuturesprice
minusthenewfuturesprice. Subtractingnetpricefrom
100 gives the investor the realized yield and thus the
investor's return from the combined futures and cash
markets.Becauserateshaveincreased,thenewlowercash
marketprice(higheryield)isincreasedbythelossfrom
the futures contract's position, which reduces realized
yield. The reading expresses this net price in several
forms,butallarethesameformulawithrearrangedterms.
24.(1998CFALevelIsampleexam)
(c)interestrateriskandreinvestmentrisk

67

CHAPTER19
AnswerstoProblems
1.Assumingannualcompounding

Modifiedduration=7/1.10=6.36years

Percentagechangeinportfolio=+2x6.36=12.72percent
Valueofportfolio=$50millionx1.1272
=$56.36million
2(a). $200millionx(1.06)2=$224.72million
2(b). Theapproximatechangeis8percent(modifieddurationof
4yearsanda200basispointchange).Thiswouldimplya
new portfolio value of ($224.72 million x 1.08) =
$242,697,600.
3(a). ComputationofDuration(assuming10%marketyield)
(1)(2)(3)(4)(5)(6)
PVas%
YearCashFlowPV@10%PVofFlowofPrice(1)x(5)

1 120
.9091
109.09
.1014
.1014
2
120
.8264
99.17
.0922
.1844
3
120
.7513
90.16
.0838
.2514
4
120
.6830
81.96
.0762
.3047
51120
.6209695.41.64643.2321
Sum
1075.791.00004.0740
Duration=4.07years
3(b). ComputationofDuration(assuming10%marketyield)
(1)(2)(3)(4)(5)(6)
PVas%
YearCashFlowPV@10%PVofFlowofPrice(1)x(5)

1
120
.9091
109.09
.1026
.1026
2
120
.8264
99.17
.0922
.1864
3
120
.7513
90.16
.0848
.2544
4 1120
.6830764.96.71942.8776
Sum
1063.381.00003.4210
Duration=3.42years
68

3(c). Thedurationoftheportfolioshouldalwaysbeequalto
the remaining time horizon and duration declines slower
than termtomaturity assuming no change in market
interestratesasshowninaandbabove.
4(a).ComputationofDuration(assuming8%marketyield)
(1)(2)(3)(4)(5)(6)
PVas%
YearCashFlowPV@8%PVofFlowofPrice(1)x(5)

1
100
.9259
92.59
.0868
.0868
2
100
.8573
85.73
.0804
.1608
3
100
.7938
79.38
.0745
.2235
4 1100
.7350808.50.75833.0332
Sum
1066.201.00003.5043
Duration=3.5years
4(b).ComputationofDuration(assuming12%marketyield)
(1)(2)(3)(4)(5)(6)
PVas%
YearCashFlowPV@12%PVofFlowofPrice(1)x(5)

1
100
.8929
89.29
.0951
.0951
2
100
.7972
79.72
.0849
.1698
3
100
.7118
71.18
.0758
.2274
4 1100
.6355699.05.74422.9768
Sum
939.241.00003.4691
Duration=3.47years
4(c).Aportfolioofbondsisimmunizedfrominterestraterisk
ifthedurationoftheportfolioisalwaysequaltothe
desired investment horizon. Considering parts (a) and
(b),thereisachangeinthemarketyieldwhichcausesa
changeintheduration,thereforetheportfolioislonger
perfectlyimmunized.
5(a). Thedurationofazerocouponbondisalwaysequaltoits
termtomaturity(10years).
5(b). P=$1,000(.2584)=$258.40(7%for20periods)
5(c). P=$1,000(.3769)=$376.90(5%for20periods)
5(d). Currentprice=1,000(.3503)=$350.30(6%for18periods)
69


350.30376.9026.60
Rateofreturn===7.06%
376.90376.90
6.CurrentCandidate
BondBond

Dollarinvestment839.54961.17
Coupon90.00110.00
iononecoupon2.593.16
Principalvalueatyearend841.95961.71
Totalaccrued934.541,074.87
Realizedcompoundyield11.012511.4988
Valueofswap:48.6basispointsinoneyear
Computations:

Price=45x(16.04612)+1,000x(.11746)=839.54
where16.04612isthePVIFAfactorand.11746isthePVIF
factorfor40periodsat5.5percentperperiod.
Price=55x(15.53300)+1,000x(.10685)=961.17
where15.53300isthePVIFAfactorand.10685isthePVIF
factorfor40periodsat5.75percentperperiod.
Price=45x(15.80474)+1,000x(.13074)=841.95
where15.53300isthePVIFAfactorand.13074isthePVIF
factorfor38periodsat5.5percentperperiod.
Price=55x(15.31315)+1,000x(.11949)=961.71
where15.31315isthePVIFAfactorand.11949isthePVIF
factorfor38periodsat5.75percentperperiod.
7.CurrentCandidate
BondBond

Dollarinvestment868.21849.09
Coupon90.0090.00
iononecoupon2.362.36
Principalvalueatyearend869.40869.40
Totalaccrued961.76961.76
Realizedcompoundyield10.49912.856
Valueofswap:235.7basispointsinoneyear

70

Computations:

Price=45x(17.57281)+1,000x(.07743)=868.21
where17.57281isthePVIFAfactorand.07743isthePVIF
factorfor50periodsat5.25percentperperiod.
Price=45x(17.24714)+1,000x(.07297)=849.09
where17.24714isthePVIFAfactorand.07297isthePVIF
factorfor50periodsat5.375percentperperiod.
Price=45x(17.41389)+1,000x(.08577)=869.40
where17.41389isthePVIFAfactorand.08577isthePVIF
factorfor48periodsat5.25percentperperiod.
8.CFAExamIII(June1984)
8(a).Activemanagement(orexpectationsmanagement)seeksthe
highestreturnpossible(abovebondmarketreturns)while
notexceedingthedesiredriskposture.Thisisdone
throughaprocessconsistingof:
(1)Formationofexpectationsaboutinterestrates,credit
riskandspreadchanges.
(2)Theirtransformationintoreturnandriskmeasuresvia
areturnsimulationprocess.
(3)Theirimplementationviaanoptimizationroutinefor
theactualbuildingoftheportfolio.
Reinvestmentrateriskisnotprotectedagainstinany
systematicwayandis,therefore,ofrealconcern.It
mustbeconsideredwhenmakingallportfoliochanges,as
itisoneofthemostimportantcomponentsofthetotal
returnthatwillbeachieved.
8(b).Classicalimmunizationcanbedefinedbyanyofthe
following:
(1)Anyinvestmentstrategydesignedtominimizetherisk
ofreinvestmentoveraspecifictimehorizon.
(2)Beingassuredthattheassetsattheendofthe
horizonperiodaregreaterthan,orequalto,some
minimumlevelthatmighthavebeenestablished.
(3)Achievingthemaximumreturnpossiblewithminimum
reinvestmentrisk.

71

Theclassicalimmunizerspendsaconsiderableamountof
timerebalancingtheportfoliotobringthedurationof
theportfoliobackinlinewiththedurationofthe
liabilitiesthatarebeingimmunized.Thisisbecause
classicalimmunizationisbasedonthreeunrealistic
assumptions:(1)aflatyieldcurve,(2)parallelyield
curveshifts,and(3)aninstantaneouschangeinyields.
Reinvestmentrateriskissignificantlyreducedoralmost
eliminatedbymatchingdurationtothetimehorizon.The
priceriskisintheoppositedirectionofthe
reinvestmentrisk,andtheseoffsettingrisksequaleach
otherwhenthedurationoftheportfolioisequaltothe
investmenthorizonoftheportfolio.
8(c).Dedicatedportfolioareusedtogeneratesufficientcash
tofinanceeachofasequenceofliabilitypaymentsas
theycomedue,withvirtuallynointerestraterisk.This
isaccomplishedusingoneoftwotechniques:(1)acash
matchedportfolioor(2)adurationmatchedportfolio.
Atleasttwopracticalproblemsintroducesome
reinvestmentrisk:(a)theriskthatbondsinthe
portfoliomaybecalledpriortomaturity;and(b)inthe
caseofcashmatching,thelifeoftheliabilitiesmay
extendbeyondthenormalmaturityrangeofbonds.Ifthe
amountoftheliabilitiesdiminishesovertime,thenthe
reinvestmentriskisfurtherreduced.
Conventionally,aconservativereinvestmentrateischosen
torepresentthatrateatwhichcashflowsareassumedto
bereinvestedfromthedatetheyarereceivedthrough
couponsandmaturitiesuntilthepaymentdateofthe
liabilitybeingfinanced.
9.Therearerisksinvolvedineitherlengtheningor
shorteningportfoliodurationinanticipationofrate
changes.Specifically,shorteningdurationswhenan
interestrateriseisexpectedfacestheriskof(1)the
rateforecastturningouttobewrong,thenportfoliowill
notbewellpositionedtoearncapitalgainsshouldrates
fall,and(2)incomereturnsforshortertermbondsare
generallylower,soshorteningthedurationalsoleadsto
lowerportfolioincome.Ontheotherside,lengthening
durationwhenadeclineininterestratesisanticipated,
(1)runstheriskoftheportfolio'svaluedeclining
sharplyshouldratesriseratherthanfalland(2)when
theyieldcurveisinverted,theinvestorwillsacrifice

72

currentincomebyshiftingfromhighcouponshortbondsto
longerdurationbonds.
10.NumberofCashFlowDuration
Futures=xConversionxAdjusted
ContractsValueof1ContractFactorFactor
$25million8.5
=x1.05x
Valueof1Contract6.0
Thisproblemmaybecompletedbydeterminingthevalueof
aTbondfuturescontractasquotedinthefinancial
sectionofanewspapersuchasTheWallStreetJournal.
11.StudentExercise
ContributionofContributionofthe
12.TargetDuration=CurrentBondxFuturesComponent
Portfolio
Fx$105,000
12(a).5.0=(.95x4.3)+x8.0
$50million
=4.085+.01680F
F=54.46
Sincefractionalcontractsdonotexist,youwouldround
tothenearestintegerandpurchase54contracts.
Fx$105,000
12(b).8.0=(.95x4.3)+x8.0
$50million
F=233.04
Roundingtothenearestinteger,youwouldpurchase
233contracts.
Fx$105,000
12(c).3.0=(.95x4.3)+x8.0
$50million
F=64.58
Roundingtothenearestinteger,youwouldsell
73

65contracts.
Fx$105,000
12(d).0.0=(.95x4.3)+x8.0
$50million
F=243.15
Roundingtothenearestinteger,youwouldsell
243contractsinordertomaketheportfolioinsensitive
tochangesininterestrates.
13.StudentExercise

74

Chapter19
AnswerstoSpreadsheetExercises
1.

PureYieldPickupSwap
S Bond

P Bond

Periods
2
Price
$874.12
yield
0.115
Par Value
1000
Sell price
$874.66
sell after
1yrs
Coupon
0.1
Reinvest
0.115
maturity
30
FV
$102.875
Total value $977.54
realiz yld
11.83%

Periods
Price
yield
Par Value
Sell price
sell after
Coupon
Reinvest
maturity
FV
Total value
realiz yld

2
$1,000.00
0.12
1000
$1,000.00
1yrs
0.12
0.12
30
$123.600
$1,123.60
12.36%

Valueofswap=0.53%
SubstitutionSwap
S Bond
Periods
Price
yield
Par Value
Sell price
sell after
Coupon
Reinvest
maturity
FV
Total value
realiz yld

P Bond
2
$1,000.00
0.12
1000
$1,000.00
1yrs
0.12
0.12
30
$123.600
$1,123.60
12.36%

Periods
Price
yield
Par Value
Sell price
sell after
Coupon
Reinvest
maturity
FV
Total value
realiz yld

Valueofswap=1.82%
2.

StudentExercise

75

2
$984.08
0.122
1000
$1,000.00
1yrs
0.12
0.12
30
$123.600
$1,123.60
14.18%