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Published by Ajay Maheska

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Published by: Ajay Maheska on Aug 31, 2012
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1

CHAPTER TWENTY-TWO
BOND PORTFOLIO
MANAGEMENT
2
BOND PORTOLIOS
• METHODS OF MANAGEMENT
– Passive
• rests on the belief that bond markets are semi-strong
efficient
• current bond prices viewed as accurately reflecting
all publicly available information

3
BOND PORTOLIOS
• METHODS OF MANAGEMENT
– Active
• rests on the belief that the market is not so efficient
• some investors have the opportunity to earn above-
average returns
4
BOND PRICING THEOREMS
• 5 BOND PRICING THEOREMS
– for a typical bond making periodic coupon
payments and a terminal principal payment
5
BOND PRICING THEOREMS
• 5 BOND PRICING THEOREMS
– THEOREM 1
• If a bond’s market price increases
• then its yield must decrease
• conversely if a bond’s market price decreases
• then its yield must increase
6
BOND PRICING THEOREMS
• 5 BOND PRICING THEOREMS
– THEOREM 2
• If a bond’s yield doesn’t change over its life,
• then the size of the discount or premium will
decrease as its life shortens
7
BOND PRICING THEOREMS
• 5 BOND PRICING THEOREMS
– THEOREM 3
• If a bond’s yield does not change over its life
• then the size of its discount or premium will
decrease
• at an increasing rate as its life shortens
8
BOND PRICING THEOREMS
• 5 BOND PRICING THEOREMS
– THEOREM 4
• A decrease in a bond’s yield will raise the bond’s
price by an amount that is greater in size than the
corresponding fall in the bond’s price that would
occur if there were an equal-sized increase in the
bond’s yield
• the price-yield relationship is convex
9
BOND PRICING THEOREMS
• 5 BOND PRICING THEOREMS
– THEOREM 5
• the percentage change in a bond’s price owing to a
change in its yield will be smaller if the coupon rate
is higher
10
CONVEXITY
CONVEXITY DEFINITION:

– a measure of the curvedness of the price-yield
relationship
11
CONVEXITY
• THE PRICE-YIELD RELATIONSHIP
YTM
Price
12
CONVEXITY
• THEOREM 1 TELLS US
– price and yield are inversely related but not in a
linear fashion (see graph)
– an increase in yield is associated with a drop in
bond price
– but the size of the change in price when yield
rises is greater than the size of the price change
when yield falls
13
DURATION
• DEFINITION:
– measures the “average maturity” of a stream of
bond payments
– it is the weighted average time to full recovery
of the principal and interest payments
14
DURATION
• FORMULA


where P
0
= the current market price of
the bond
PV(C
t
)= the present value of the
coupon payments
t = time periods


¿
=
(
¸
(

¸

=
T
t
t
t
P
C PV
D
1
0
) (
15
DURATION
• THE RELATION OF DURATION TO
PRICE CHANGES
– THEOREM 5 implies
• bonds with same maturity date but different coupon
rates may react differently to changes in the interest
rate
• duration is a price-risk indicator
16
DURATION
• DURATION IS A PRICE-RISK
INDICATOR
– FORMULA


rewritten

where y = the bond’s yield to maturity
| | ) 1 ( ytm D
p
p
+ A ÷ ~
A
|
|
.
|

\
|
+
A
÷ ~
A
y
y
D
p
p
1
17
DURATION
• MODIFIED DURATION
– FORMULA:


– reflects the bond’s % price change for a one
percent change in the yield
y
D
D
m
+
=
1
18
DURATION
• THE RELATIONSHIP BETWEEN
CONVEXITY AND DURATION
– whereas duration would have us believe that the
relationship between yield and price change is
linear
– convexity shows us otherwise
19
DURATION
• THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION


YTM
P
C
0
20
IMMUNIZATION
• DEFINITION: a bond portfolio
management technique which allows the
manager to be relatively certain of a given
promised cash stream
21
IMMUNIZATION
• HOW TO ACCOMPLISH
IMMUNIZATION
– Duration of a portfolio of bonds
• equals the weighted average of the individual bond
durations in the portfolio
– Immunization
• calculate the duration of the promised outflows
• invest in a portfolio of bonds with identical
durations
22
IMMUNIZATION
• PROBLEMS WITH IMMUNIZATION
– default and call risk ignored
– multiple nonparallel shifts in a nonhorizontal
yield curve
– costly rebalancing ignored
– choosing from a wide range of candidate bond
portfolios is not very easy
23
ACTIVE MANAGEMENT
• TYPES OF ACTIVE MANAGEMENT
– Horizon Analysis
• simple holding period selected for analysis
• possible yield structures at the end of period are
considered
• sensitivities to changes in key assumptions are
estimated
24
ACTIVE MANAGEMENT
• TYPES OF ACTIVE MANAGEMENT
– Bond Swapping
• exchanging bonds to take advantage of superior
ability to predict yields
• Categories:
– substitution swap
– intermarket spread swap
– rate anticipation swap
– pure yield pickup swap
25
ACTIVE MANAGEMENT
• TYPES OF ACTIVE MANAGEMENT
– Contingent Immunization
• portfolio managed actively as long as favorable
results are obtained
• if unfavorable, then immunize the portfolio
26
PASSIVE MANAGEMENT
• TYPES OF PASSIVE MANAGEMENT
– INDEXATION
• the portfolio is formed to track a chosen index

BOND PORTOLIOS
• METHODS OF MANAGEMENT
– Passive
• rests on the belief that bond markets are semi-strong efficient • current bond prices viewed as accurately reflecting all publicly available information

2

BOND PORTOLIOS • METHODS OF MANAGEMENT – Active • rests on the belief that the market is not so efficient • some investors have the opportunity to earn aboveaverage returns 3 .

BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – for a typical bond making periodic coupon payments and a terminal principal payment 4 .

BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 1 • • • • If a bond’s market price increases then its yield must decrease conversely if a bond’s market price decreases then its yield must increase 5 .

• then the size of the discount or premium will decrease as its life shortens 6 .BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 2 • If a bond’s yield doesn’t change over its life.

BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 3 • If a bond’s yield does not change over its life • then the size of its discount or premium will decrease • at an increasing rate as its life shortens 7 .

BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 4 • A decrease in a bond’s yield will raise the bond’s price by an amount that is greater in size than the corresponding fall in the bond’s price that would occur if there were an equal-sized increase in the bond’s yield • the price-yield relationship is convex 8 .

BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 5 • the percentage change in a bond’s price owing to a change in its yield will be smaller if the coupon rate is higher 9 .

CONVEXITY CONVEXITY DEFINITION: – a measure of the curvedness of the price-yield relationship 10 .

CONVEXITY • THE PRICE-YIELD RELATIONSHIP Price YTM 11 .

CONVEXITY • THEOREM 1 TELLS US – price and yield are inversely related but not in a linear fashion (see graph) – an increase in yield is associated with a drop in bond price – but the size of the change in price when yield rises is greater than the size of the price change when yield falls 12 .

DURATION • DEFINITION: – measures the “average maturity” of a stream of bond payments – it is the weighted average time to full recovery of the principal and interest payments 13 .

DURATION • FORMULA  PV (Ct ) D   P t 1  0 T  t  where P0 = the current market price of the bond PV(Ct )= the present value of the coupon payments t = time periods 14 .

DURATION • THE RELATION OF DURATION TO PRICE CHANGES – THEOREM 5 implies • bonds with same maturity date but different coupon rates may react differently to changes in the interest rate • duration is a price-risk indicator 15 .

DURATION • DURATION IS A PRICE-RISK INDICATOR – FORMULA p   D(1  ytm) p rewritten  y  p   D 1 y   p   where y = the bond’s yield to maturity 16 .

DURATION • MODIFIED DURATION D – FORMULA: Dm  1 y – reflects the bond’s % price change for a one percent change in the yield 17 .

DURATION • THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION – whereas duration would have us believe that the relationship between yield and price change is linear – convexity shows us otherwise 18 .

DURATION • THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION P C 0 YTM 19 .

IMMUNIZATION • DEFINITION: a bond portfolio management technique which allows the manager to be relatively certain of a given promised cash stream 20 .

IMMUNIZATION • HOW TO ACCOMPLISH IMMUNIZATION – Duration of a portfolio of bonds • equals the weighted average of the individual bond durations in the portfolio – Immunization • calculate the duration of the promised outflows • invest in a portfolio of bonds with identical durations 21 .

IMMUNIZATION • PROBLEMS WITH IMMUNIZATION – default and call risk ignored – multiple nonparallel shifts in a nonhorizontal yield curve – costly rebalancing ignored – choosing from a wide range of candidate bond portfolios is not very easy 22 .

ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT – Horizon Analysis • simple holding period selected for analysis • possible yield structures at the end of period are considered • sensitivities to changes in key assumptions are estimated 23 .

ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT – Bond Swapping • exchanging bonds to take advantage of superior ability to predict yields • Categories: – – – – substitution swap intermarket spread swap rate anticipation swap pure yield pickup swap 24 .

ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT – Contingent Immunization • portfolio managed actively as long as favorable results are obtained • if unfavorable. then immunize the portfolio 25 .

PASSIVE MANAGEMENT • TYPES OF PASSIVE MANAGEMENT – INDEXATION • the portfolio is formed to track a chosen index 26 .

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