Professional Documents
Culture Documents
Week 6
Fixed Income Securities
Greg Vaughan
Disequilibrium Example
E(r)
SML
15%
Rm=11%
rf=3%
1.0 1.25
4
A
i
= wi wi
A
i
P
i
>0
) the single-
(e )
i
..we are concerned only with the aggregate beta of the active
portfolio, rather than the beta of each individual security.
Normally this is zero by design, so that portfolio beta is one.
Active weights are scaled based on target tracking error
6
1 2
2
Frequency
Skewness
Excess
Kurtosis
Probability
of Normality
Monthly
-3.1
30.3
0%
Quarterly
-1.8
8.8
0%
Annual
-0.5
0.8
56%
11
12
13
14
Bond
Pricing:
Two
Types
of
Yield
Curves
16
Uses
recently-issued
coupon
bonds
selling
at
or
near
par
The
one
typically
published
by
the
nancial
press
Current Yield
17
19
Bond
Yields:
Realized
Yield
versus
YTM
Reinvestment
Assump=ons
Holding
Period
Return
Changes
in
rates
aect
returns
Reinvestment
of
coupon
payments
Change
in
price
of
the
bond
20
21
YTM
HPR
Yield components
Real risk-free interest rate +
Expected inflation rate +
Maturity Premium
=Sovereign Bond Yield
Liquidity Premium +
Credit spread
= Corporate Bond Spread
Corporate Bond Yield = Sovereign Yield + Corporate Spread
Corporate Bond Spreads increase with maturity.
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23
25
Bank bills
27
# y&
P = Ct %1+ (
$ 2'
2t1
$ y'
dP
= Ct (2t ) &1+ )
% 2(
dy
! dP $
# &
! 1 $
" dy %
= #
& t wt
P
" 1+ y / 2 %
28
2t
$1' $ 1 '
$ y'
& ) = &
) Ct t &1+ )
% 2 ( % 1+ y / 2 (
% 2(
where
2t
" y%
wt = Ct $1+ '
# 2&
/P
The duration is the weighted average term of cash flows with weights
determined as the proportion of valuation at that point in time
MacaulayDuration = t wt
2t
where
" y%
wt = Ct $1+ '
# 2&
" dP %
$ '
1
# dy &
ModifiedDuration =
=
MacaulayDuration
P
(1+ y / 2)
29
/P
2 P y
Consider a ten year 4% coupon bond with the market yield at 3%.
30
Rule
2
Holding
maturity
constant,
a
bonds
dura=on
is
higher
when
the
coupon
rate
is
lower
Rule
3
Holding
the
coupon
rate
constant,
a
bonds
dura=on
generally
increases
with
its
=me
to
maturity
31
Rules 5
32
h2
f (x + h) = f (x) + h f "(x) +
f ""(x) +....
2!
P+ + P 2 P
Convexity
2 P (y)2
33
( )
P
= 8.30 0.0050 + 0.5 40.3 0.0050 2 = 4.10%
P
However these concepts are relevant in risk management (eg what is the
duration of the fixed interest portfolio)
34
( )
Immunization issues
To achieve greater convexity than liabilities, the asset
portfolio will have a wider spread of maturities eg maturity
barbell
This is OK if the yield curve experiences a parallel shift
However if the yield curve steepens for example at the
same time as shifting, the high convexity portfolio will
underperform a matched convexity portfolio
Need to model the risks of asset/liability mismatch more
thoroughly
37
38
39
Recovery Rating