Professional Documents
Culture Documents
Course coverage.
Day 1 Session 1 Types of Treasury Markets Money Markets Govt. Securities Markets Session 2 Macro-economic analysis for treasury markets Session 3 Bond Mathematics Session 4 Bond Mathematics continued. Day 2 Session 1 Valuation of floating rate bonds and bonds with embedded options Types of risks Session 2 Interest rate risk measurement Session 3 Bond portfolio Planning and Management Strategies Session 4 Bond portfolio Planning and Management Strategies continued.
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Session 1
Session 1 covers.
Domestic and Forex Treasury Money Market
Call Money Market, CBLO T Bills, CPs and CDs Liquidity Adjustment Facility Fund Flow in the system CRR and SLR Interbank REPOs
Session 1 covers.
Government Securities Market Size & Products Various types of G Secs. issued Auction Mechanism & Role of Primary Dealers SLR Securities Trading & Settlement System
Sho
m ter rt
Money Market
Financial System
Long t er m
Money Market
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Under notice money market, funds are transacted for the period between 2 to 14 days.
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Call/Notice Market
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NDS- Call
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CBLO is a discounted instrument issued in electronic book entry form for the maturity period ranging from one day to one year.
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CBLO Market
CBLO Collateralized Borrowing and Lending Obligation is a part of money market and is open for all categories of participants such as banks, PDs, FIs, MFs, PFs, Corporates etc. Need for CBLO Since call money market is an inter-bank market, CBLO provides an excellent mechanism for banks as well as nonbank participants to manage short term liquidity.
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CBLO Market
(in Rs mn)
Source : CCIL
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Source : CCIL
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Treasury Bills
Treasury bills are short-term negotiable securities issued in their domestic money markets by Governments. They are used for short term funding as well as to control the money supply in the economy. They do not pay interest but are traded at discount to their par value or face value. They are the most liquid part of the money markets.
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Treasury bills
Auction day Wednesday of every week Every alternate Wednesday (which is not a reporting week ) Every alternate Wednesday (which is a reporting week )
182-day
364-day
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Date of Auction 6-May-09 13-May-09 20-May-09 27-May-09 3-Jun-09 10-Jun-09 17-Jun-09 24-Jun-09 1-Jul-09 8-Jul-09 15-Jul-09 22-Jul-09 29-Jul-09
3.2754 3.3162 3.3570 3.3570 3.3570 3.3162 3.1124 3.2347 3.2754 3.2754 3.2347
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Commercial paper
Commercial Papers are negotiable short-term unsecured promissory notes with fixed maturities, issued by well rated companies generally sold on discount basis. These are basically instruments evidencing the liability of the issuer to pay the holder in due course a fixed amount (face value of the instrument) on the specified due date.
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Commercial paper
Features Commercial Papers when issued in Physical Form are negotiable by endorsement and delivery and hence highly flexible instruments Issued subject to minimum of Rs 5 lakhs and in the multiples of Rs. 5 Lac thereafter, Maturity is 7 days to 1 year Unsecured and backed by credit of the issuing company
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Commercial paper
Eligibility Criteria Any private/public sector co. wishing to raise money through the CP market has to meet the following requirements: Tangible net-worth not less than Rs 4 crore - as per last audited statement. Should have Working Capital limit sanctioned by a bank / FI. Credit Rating not lower than P2 or its equivalent - by Credit Rating Agency approved by Reserve Bank of India. Board resolution authorizing company to issue CPs PD and AIFIs can also issue Commercial Papers
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Commercial paper
The cash leg is settled through RTGS or high value. RBI cheques cannot be issued for settlement of CPs. The settlement of CPs is compulsorily in a demat mode.
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C Ps issued
Year:2009
Company name Tata Motors Tata Capital Godrej & Boyce Hindustan construction company Issue date January January July July Amount 500 million Rs 2.5 Billion Rs 200 million Rs 300 million Coupon rate 10.4% 11.1% 4.35% 5.65% Maturity May March Dec Oct
Source: Reuters
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Certificate of Deposit
Issued by banks for specified period of time and at a specified rate of interest. It is a time deposit with the bank. They offer a slightly higher yield than T-Bills because of higher default risk. In short, they are transferable, negotiable, short term, fixed interest bearing, maturity dated money market instruments.
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Certificate of Deposit
The maturity period of the CDs for banks varies between 15 days to 1 year. For FIs, the tenor of the maturity can extend upto 3 years. Here also, the cash leg is settled through RTGS or high value and RBI cheques cannot be issued for settlement. The settlement of CDs is compulsorily in a demat mode.
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C Ds issued
Company name United bank of India Punjab National Bank IDBI Issue date August 09 December 08 December 08 Amount Rs 1 billion Rs 1 billion Coupon rate 3.71% 8.27% Maturity 3 months 6 months
Rs 1 billion
8.55%
1 year
Source: Reuters
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GOI Securities
Liabilities of GOI issued in the nature of Bonds Issued to finance budget deficits of GOI Available in both SGL & Physical form
GOI securities
RBI acts the Investment Banker , Custodian, Registrar and market Regulator Primarily, wholesale in nature Active trading & investment avenue for Banks, PDs, FIs, Insurance Cos., PFs, MFs, etc
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Products
Issued by GOI Dated Securities - Issued by GOI
Bonds which include both coupon bearing and zero coupon Initial maturity > 1 year
Issued by state government State Govt Loans - Bonds issued by State Govts.
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Floating Rate Bonds Around 10 issues so far. Capital Indexed Bond Issued in 1997 with principal indexed to inflation, Lackluster response. Issued in 2004 again with both principal and interest indexed to WPI, Lackluster response again. Callable & Puttable G Secs. Issued in 2002, only one issue so far.
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NDS-OM
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NDS-OM
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Consolidation through re-issuance of existing securities. Intra-day short selling in G Secs. allowed for banks & PDs in 2006. Short selling now extended to 5 trading days.
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Primary dealers
The role of Primary Dealers is to : (i) participate as Principals in Government of India issues through bidding in auctions (ii) provide underwriting services (3% of issue size is MUC, 3% to 30% is competitive AUC) (iii)offer firm buy - sell / bid ask quotes for T-Bills & dated securities (iv) Develop Secondary Debt Market
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Primary dealers
Deutsche Securities (India) Pvt. Ltd. ABN AMRO Bank N.V. ICICI Securities Primary Dealership Limited Bank of America STCI Primary Dealer Limited Bank Of Baroda IDBI GIlts Ltd. Kotak Mahindra Bank Ltd. Canara Bank SBI DFHI Ltd Citibank N.A PNB Gilts Ltd. Corporation Bank HDFC Bank Ltd. Hongkong and Shanghai Banking Corpn. Ltd.(HSBC) JP Morgan Chase Bank N.A, Mumbai Branch Standard Chartered Bank
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Issue Devolvement
When the undersubscription of a security issue forces the underwriting investment bank to purchase unsold securities during an offering. Devolvement is often an indication that the market currently has negative sentiments toward the issue. This negative sentiment can have a significant impact on subsequent demand. Devolvement poses substantial risk for the underwriting investment bank.
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Issue Devolvement
When it is required to purchase unsubscribed shares of an issue, it will often purchase the stock at a higher-thanmarket-value price. Because demand is lower than anticipated, there are few buyers for the security at its issued value. Typically, the investment bank will not hold onto the floundering issue for too long and will usually liquidate the shares in the market, often causing a financial loss.
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Source : CCIL
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SLR Securities
Dated securities and T bills issued by the Government of India Dated securities issued by State Government Other approved Securities
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Pension & General 20% of Total Assets Annuity Businesses NBFCs accepting public deposits 15% in liquid assets, not less than 10% in approved securities
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11.8
13.8
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6.1
7.3
7.9
8.1
Source : RBI
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Source : RBI
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Source : RBI
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Interest Rates
Inflation
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Growth Indicators
GDP growth The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. GDP = C + G + I + (Exports-imports) where: "C" is equal to all private consumption, or consumer spending, in a nation's economy; "G" is the sum of government spending; "I" is the sum of all the country's businesses spending on capital & the nation's total net exports, calculated as total exports minus total imports.
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Growth Indicators
Higher GDP or higher national output indicates greater aggregate demand for coming years. Investment decisions are based on growth rate of economy / sectors. Investments are funded by domestic savings (domestic household + private sector + public sector) and external sources. Which policy initiative is taken to support real GDP growth?
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Interest Rates
Interest rates Cost of Money in the economy, determined by demand and supply of money. Factors creating demand for liquidity Factors creating supply of liquidity Nominal Vs. real interest rates
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Interest rates
2006- 2007- 200807 08 09 Cash Reserve Ratio (%) Bank Rate (% p.a.) Inter-bank Call Money Rate (Mumbai) (%) Deposit Rate (%) (a) 30 days and 1 year (b) 1 year and above Prime Lending Rate (%) Source : RBI
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Inflation
Inflation The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Poses a major risk to fixed income markets.
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CPI
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WPI Inflation
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Commodity prices
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lending.
in call money and other short term money markets provide important information about liquidity in the system. liquidity in the short term which if continues may spread to term money market as well
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As on
July 2, 2009 July 3, 2009 July 4, 2009 July 6, 2009 July 7, 2009 July 8, 2009 July 9, 2009 July 10, 2009 July 11, 2009 July 13, 2009 July 14, 2009 July 15, 2009
Lendings
1.25 1.25 1.25 1.25 1.25 3.30 3.30 3.30 3.30 3.30 3.30 3.30 3.30 3.35 3.35 3.30 3.30
Lendings
3.18 3.13 3.22 3.17 3.13 3.16 3.17 3.21 3.25 3.23 3.23 3.22
Forward Premium
To hedge against forward Contracts entered into with exporters Banks sell spot and enter into buy sell swap (receive premium) To hedge against forward contracts entered into with importers Banks buy spot and enters into sell buy swap (pay premium)
Thus demand and supply determined forward premium. This in turn affects the MIFOR curve.
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CROMS - REPO
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Source : CCIL
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Source : RBI
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Source : RBI
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Inter-bank Repos
Banks, PDs, Mutual funds, Insurance cos etc can borrow/lend through inter-bank repo/reverse repo transactions. The maturity can be upto 1 year. It is OTC & free to be determined between 2 counterparties.
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Bank Rate
2 key bank re-finance rates are directly linked to - the bank/PD refinance levels & the export re-finance to the banks Provides the basic liquidity to the banking sector Is used as a interest rate policy signal tool by the RBI Lays down the basic interest rate structure
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Time liabilities are those which are payable otherwise than on demand, like :
Fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits. Deposits held as securities for advances which are not payable on demand. Gold deposits.
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For comparing these cash flows, we have to adjust them for time value.
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Bond Valuation
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Bond Valuation
Valuation of bond involves discounting the future cash flows at an appropriate rate to arrive at the present value of bonds.
This principle is applicable to all types of bonds, whether zero coupon or coupon bearing bonds.
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Valuing bonds
Long Term Vs. Short Term bonds
Which bonds are more volatile?
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Shortcomings of YTM
YTM is based on following assumptions, The intermediate cash flows to the investor can be reinvested at a rate equal to the yield-to-maturity and The investor holds the bond till maturity The first assumption can rarely hold true due to the dynamic nature of interest rates. Similarly the investor may not hold the bond till maturity. Hence the realized yield may be quite different from YTM, giving rise to risk.
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Bootstrapping
The zero coupon yield curve is generated by plotting the zero coupon yields on a time scale. Derive the implied spot rates from the prices and yields of coupon bonds. Treat each coupon as a mini-zero coupon bond, i.e. think of a coupon bond as a portfolio of zeros.
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Bootstrapping
Separate the cash flow, each with its own discount (spot) rate Use bonds of progressively longer maturities, starting from Tbills
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Methodology
The standard method of valuing a bond is to discount all the cash flows of the bond at a rate based on the yield available on a comparable instrument in the market. In simple terms, the cash flows to be discounted in case of floating rate bond is
Next coupon to be received which is known with certainty Value of the bond at the next coupon date
A view can be taken that the bond will reset at par. In this case the valuation of bond on any given day will be simple.
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Issues
FRBs having Zero Spread over reference rate Value this by taking only one cashflow (i.e. next coupon & principle) Value by taking multiple cash flows (all coupons and principle) FRBs having a spread over reference rate Assuming the spread has not changed since issue of this bond
Value this by taking only one cashflow (i.e. next coupon & principle) Value by taking multiple cash flows (all coupons and principle)
Assuming that the spread has changed since the issue of this bond (for corporate bonds)
Value this by taking only one cashflow (i.e. next coupon & principle) Value by taking multiple cash flows (all coupons and principle)
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Contd
At present the valuation of callable bonds in India happens on Yield to Worst basis and Valuation of puttable options is done on yield to best basis. Thus the optionality element is not considered. Let us see if this element is considered how the bond pricing can be done.
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Contd
To value a bond with an embedded option it is necessary to understand that the bond can be decomposed into an option-free component and an option component. Value of a callable bond = Value of non-callable bond - Call option premium Value of a putable bond = Value of non-putable bond + Long a put option
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Binomial Method
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Hence the valuation of bonds can be done by using Zero Coupon Yield Curve
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Price
Price Predicted by Duration
Actual Price
Y0 Y1
Y2
Yield
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Convexity
Convexity measures the change in duration when the interest rate changes. The relationship between market value and interest rate is not linear. While duration measures the market value weighted average maturity of future flows, convexity is a function of dispersion of flows around that average. Zero Coupon bonds will have lowest convexity, other things being equal.
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Convexity
Duration is an accurate measure only for small yield changes. Convexity combined with duration allows us to do better approximation of price than using duration alone. Convexity = {t*(t+1)*CF/(1+r)^t}/P
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Convexity
Convexity measures how duration changes with interest rates. It is the second derivative of price with respect to yield. 1 d2P
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Barbell Strategy
Barbells are a strategy for buying short-term and longterm bonds, but not intermediate-term bonds. The long-term end of the barbell allows you to lock into attractive long-term interest rates, while the short-term end insures that you will have the opportunity to invest elsewhere if the bond market takes a downturn. Essentially, the barbell strategy is built around the concept of focusing on the maturities of the securities that are part of the portfolio and making sure that the maturity dates are either very close or at a distant date.
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Barbell Strategy
This is how it works : When you see appealing long-term interest rates, you buy two long-term bonds. You also buy two short-term bonds. When the short-term bonds mature, you receive the principal and have the opportunity to reinvest it. This means that two blocs or groups are created within the portfolio, rather than having securities that mature consistently from one period to the next.
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Barbell Strategy
Part of the purpose of the barbell strategy is to allow for a quick turnover of a significant amount of the assets in the portfolio at one time. For example, attention should be paid to the bloc of shortterm investments, so they can all be rolled over into new short-term investments as they reach maturity. Typically, this leads to an increase in the value of the investments that are turned over, thus increasing the overall value of the investment portfolio.
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Credit analysis models such as Altmans Z-score model may be useful for predicting changes in ratings High yield bonds may warrant special attention
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Substitution swap
Swapping a seemingly identical bond for one that is currently thought to be undervalued
Tax swap
Swap in order to manage tax liability
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Matched-Funding Techniques
Matched-Funding Techniques Classical (pure) immunization Dedicated portfolio Horizon Matching
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Matched-Funding Techniques
Classical (pure) immunization strategies attempt to earn a specified rate of return regardless of changes in interest rates. Must balance the components of interest rate risk
Price risk: problem with rising interest rates Reinvestment risk: problem with falling interest rates
Immunize a portfolio from interest rate risk by keeping the portfolio duration equal to the investment horizon
Duration strategy superior to a strategy based only a maturity since duration considers both sources of interest rate risk
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Matched-Funding Techniques
Immunization Strategies Difficulties in Maintaining Immunization Strategy Rebalancing required as duration declines more slowly than term to maturity Modified duration changes with a change in market interest rates Yield curves shift
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Matched-Funding Techniques
Dedicated portfolios Designing portfolios that will service liabilities Different types: Exact cash match
Conservative strategy, matching portfolio cash flows to needs for cash Useful for sinking funds and maturing principal payments
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Matched-Funding Techniques
Horizon matching Combination of cash-matching and immunization With multiple cash needs over specified time periods, can duration-match for the time periods, while cash-matching within each time period.
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Contingent Procedures
Contingent procedures are a form of structured active management. The procedure immunization. here is referred to as contingent
It provides an opportunity to the portfolio manager to actively manage the portfolio with a structure that constrains the portfolio manager if he/she is unsuccessful.
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Contingent Procedures
Contingent Immunization It allows a bond portfolio manager to pursue the highest returns available through active strategies, while relying on classical bond immunization techniques to ensure a given minimal return over the investment horizon. In simpler terms, it allows active portfolio management with a safety net provided by classical immunization. This technique requires the client to willingly accept a potential return below the current market return, referred to as a cushion spread - i.e. the difference between the current market return and some floor rate. This cushion spread in required yield provides flexibility for the portfolio manager to engage in active portfolio strategies.
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Bond analytics
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Curve Flatteners/Steepeners
Bull Flattener A yield-rate environment in which long-term decreasing at a rate faster than short-term rates. rates are
This causes the yield curve to flatten as the short-term and long-term rates start to converge. If the yield curve is exhibiting bull flattener behavior, the spread between the long-term rate and the short-term rate is getting smaller because long-term rates are decreasing as shortterm rates are increasing. This could occur as more investors choose long-term bonds relative to short-term bonds, which drives long-term bond prices up and reduces yields.
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Curve Flatteners/Steepeners
Bear Flattener A yield-rate environment in which short-term interest rates are increasing at a faster rate than long-term interest rates. This causes the yield curve to flatten as short-term and longterm rates start to converge. If the curve is flattening, the spread between long-term rates and short-term rates is narrowing. A bear flattener often occurs when the government raises interest rates in the short term. Increasing interest rates drives short-term bond prices down, increasing their yields rapidly in the short term, relative to long-term securities.
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Curve Flatteners/Steepeners
Bull Steepener A change in the yield curve caused by short-term rates falling faster than long-term rates, resulting in a higher spread between the two rates. When the yield curve is said to be a bull steepener it means that the higher spread is caused by the short-term rates, not long-term rates. A steepener differs from a flattener in that a steepener widens the yield curve while a flattener causes long-term and short-term rates to move closer together.
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Curve Flatteners/Steepeners
Bear Steepener A widening of the yield curve caused by long-term rates increasing at a faster rate then short-term rates. This causes a larger spread between the two rates as the long-term rate moves further away from the short-term rate. This widening yield curve is similar to a bull steepener except with a bear steepener this is driven by the changes in long-term rates, compared to a bull steepener where short-term rates have a greater effect on the yield curve.
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Spread Analytics
Zero Volatility Spread (Z-Spread) It is a tool used in the analysis of an asset swap that uses the zero-coupon yield curve to calculate the spread. The Z-spread is the number of basis points that would have to be added to the spot yield curve so that the bond's discounted cash flows equal the bond's present value. Each cash flow is discounted using its maturity and the spot rate for that maturity term, so each cash flow has its own zero-coupon rate. The spread is calculated iteratively and provides a more accurate reflection of value than other measures as it uses the entire yield curve to value the cash flows.
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Spread Analytics
Option adjusted spread Option adjusted spread (OAS) is the flat spread over the treasury yield curve required to discount a security payment to match its market price. This concept can be applied to mortgage-backed security (MBS), Options, Bonds and any other interest-rate Derivative. The OAS describes the market premium over a model including two types of volatility: Variable interest rates Variable prepayment rates.
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