Main Examination Period 2018

ECOM074 Bond Market Strategies Duration: 2 hours

YOU ARE NOT PERMITTED TO READ THE CONTENTS OF THIS QUESTION PAPER UNTIL
INSTRUCTED TO DO SO BY AN INVIGILATOR

Answer all 12 questions

Calculators are permitted in this examination. Please state on your answer book the name and
type of machine used.

Complete all rough workings in the answer book and cross through any work that is not to be
assessed.

Possession of unauthorised material at any time when under examination conditions is an

assessment offence and can lead to expulsion from QMUL. Check now to ensure you do not have
any notes, mobile phones, smartwatches or unauthorised electronic devices on your person. If you
do, raise your hand and give them to an invigilator immediately.

It is also an offence to have any writing of any kind on your person, including on your body. If you
are found to have hidden unauthorised material elsewhere, including toilets and cloakrooms it will
be treated as being found in your possession. Unauthorised material found on your mobile phone
or other electronic device will be considered the same as being in possession of paper notes. A
mobile phone that causes a disruption in the exam is also an assessment offence.

EXAM PAPERS MUST NOT BE REMOVED FROM THE EXAM ROOM

Examiner: Darren Cullen

© Queen Mary, University of London, 2018

Page 2 ECOM074 (2018)

Question 1

Consider a French investment fund that has a €250 million position in a 20-year Spanish
government bond. This bond has a 5.75% coupon rate, a par value of €100, an annual
coupon payment frequency and a yield to maturity of 1.85%. How much would the fund
lose if the yield to maturity for this bond increased by 100 basis points to 2.85%? Explain
your answer clearly.

[6 marks]

Question 2

Consider a 5-year Swiss government zero-coupon bond with a par value of CHF100.
Calculate the price for this bond using a –0.5% (minus 0.5%) yield to maturity. Assume an
annual coupon payment frequency for your calculations. Explain your answer and
comment on the result.

[6 marks]

Question 3

What are the limitations of using duration and convexity in active bond portfolio strategies?

[6 marks]

Question 4

Consider a 20-year Euro area zero-coupon bond that has a par value of €100 and is
priced at €58.125.

a) Calculate the implied yield to maturity for this bond.

b) What is the relationship between the implied yield to maturity and the implied
spot rate for this bond?
[4 marks]

Question 5

Consider a 30-year US Treasury bond with a 2.5% coupon rate, a semi-annual coupon
payment frequency and a par value of $100. This bond has a duration of 20.9 and a
convexity of 561. Use a Taylor series approximation to estimate the per cent change in the
price of this bond if the yield to maturity is increased by 100 basis points. Explain your
answer and comment on the result.

[8 marks]
ECOM074 (2018) Page 3

Question 6

Consider a UK pension fund that has a £100 million position in a 40-year UK Gilt. This
bond has a 1.75% coupon rate, a par value of £100, a semi-annual coupon payment
frequency and a 2% yield to maturity. How much would the pension fund lose if the yield
on this long-term Gilt increased by 100 basis points to 3%? Explain your answer clearly
and comment on the result.

[8 marks]

Question 7

Describe inflation-indexed bonds and explain the break-even inflation concept.

[8 marks]

Question 8

Explain how US sub-prime mortgage loans contributed to the global financial crisis.

[8 marks]

Question 9

Bond traders and portfolio managers watch central banks closely to gain an insight into
future monetary policy decisions. Briefly describe how central bank policies affect the yield
curve.

[8 marks]

Question 10

Record low bond yields and negative bond yields in some markets are forcing some bond
portfolio managers to increase risk to meet investor income requirements. Briefly describe
some of the strategies that bond fund managers use to produce extra income and explain
the associated risks.

[8 marks]

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Page 4 ECOM074 (2018)

Question 11

Consider a bond fund management firm that has made a €100 million investment in a 7-
year zero-coupon government bond. This bond has a par value of €100. Assume the
coupon payment frequency is annual. Calculate the 1-year investment return for this bond
position, in both per cent change and monetary value terms, using the spot rates in Table
1. Explain your answer and comment on the shape and the shift in the spot rate curve.

Table 1 Euro area spot rates at start date and one-year later

Maturity Spot rates Spot rates

Start date One year later

1 1.25% 1.00%

2 1.50% 1.25%

3 1.75% 1.50%

4 2.00% 1.75%

5 2.25% 2.00%

6 2.50% 2.25%

7 2.75% 2.50%

[15 marks]
ECOM074 (2018) Page 5

Question 12

A portfolio manager for a US bond fund wants to reduce the portfolio’s interest rate risk
exposure because she is expecting the Federal Reserve to continue raising interest rates
this year. The portfolio includes a selection of government, corporate and mortgage bonds
with a range of different maturities. The corporate and mortgage bonds in the portfolio are
relatively illiquid so the portfolio manager wants to use an interest rate swap overlay
strategy, instead of changing any bond positions, to achieve the desired reduction in
portfolio interest rate risk. The market value for the bond fund is $950 million and the
portfolio duration is 7.5.
a) Define an interest rate swap and explain how and why interest rate swaps are used
to change a portfolio’s interest rate risk exposure.

b) Calculate the notional principal required to reduce portfolio duration to 5.0 from 7.5
using a 10-year interest rate swap that has a duration of 8.4.

[15 marks]

End of Paper

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