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CHAPTER TWENTYTWO
BOND PORTFOLIO
MANAGEMENT
2
BOND PORTOLIOS
• METHODS OF MANAGEMENT
– Passive
• rests on the belief that bond markets are semistrong
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
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BOND PRICING THEOREMS
• 5 BOND PRICING THEOREMS
– for a typical bond making periodic coupon
payments and a terminal principal payment
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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
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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
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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
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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 equalsized increase in the
bond’s yield
• the priceyield relationship is convex
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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
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CONVEXITY
CONVEXITY DEFINITION:
– a measure of the curvedness of the priceyield
relationship
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CONVEXITY
• THE PRICEYIELD RELATIONSHIP
YTM
Price
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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
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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
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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
) (
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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 pricerisk indicator
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DURATION
• DURATION IS A PRICERISK
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
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DURATION
• MODIFIED DURATION
– FORMULA:
– reflects the bond’s % price change for a one
percent change in the yield
y
D
D
m
+
=
1
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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
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DURATION
• THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION
YTM
P
C
0
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IMMUNIZATION
• DEFINITION: a bond portfolio
management technique which allows the
manager to be relatively certain of a given
promised cash stream
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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
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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
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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
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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
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ACTIVE MANAGEMENT
• TYPES OF ACTIVE MANAGEMENT
– Contingent Immunization
• portfolio managed actively as long as favorable
results are obtained
• if unfavorable, then immunize the portfolio
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PASSIVE MANAGEMENT
• TYPES OF PASSIVE MANAGEMENT
– INDEXATION
• the portfolio is formed to track a chosen index