F528 First Group Assignment 2020 New

1F528 Fixed Income Investments
Individual Assignment 1
Deadline: April 30, 2020, at 11:59pm
1. Questions from the case study: “Fixed income Arbitrage in

a Financial Crisis (A): US Treasuries in November 2008”
a. Why did Franey do so well during the initial part of the crisis
period?
Franey did well in during the initial crisis period because he had a
lack of knowledge for mortgage securities, causing him to not invest
in them. Instead, he invested in fixed income assets like treasury
bonds. The collapse of the economy in the United States in 2008 led to
an increase in the price of treasuries because people were panicking
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about mortgage-backed securities.
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b. What is the potential arbitrage trade that Franey is considering
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on Nov 4th, 2008?
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The potential trade Franey is considering in buying treasury bonds at
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a face value of 100, yield of 3.61%, a coupon rate of 10.625%, a Val01
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of 0.0741, a modified duration of 5.14, a maturity at August 2015, and
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a price of $141.8281. Then, he would sell bonds with face values of
100, yields at 3.26%, coupon rates of 4.25%, Val01 of 0.0625, modified
duration of 5.84, a maturity date of august 2015, and a price of
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$105.9688. The trade was that each $1,000 face amount of high yield
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bond he bought +accrual $23.68 for a total of $1441.96, he would sell

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$1000 face amount of low yield bond + accrual for a total of $1267.60
and borrow $174.36. When the yield spread was 0, he would close the
position for a present value of the portfolio being $26, or 1.8% total
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return with no initial investments from KTC’s capital.

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c. How might the trade be financed? Give an explanation of the

financing risks that exist.
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The long position would be financed from the 98% lent from the
broker with an annual rate of 0.15%. The other 2% (“haircut”) will
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come from KTC and the 10.625% bonds will be collateral.

For the short position, KTC will ask their broker to find them an
investor who will lend them the 4.25% bond. Next, KTC will be selling
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the bonds from the lender and uses the cash from the transaction as
collateral. KTC will also have to post 2% of additional capital known
as the “haricut”. The unique aspect of this situation is KTC will
receive 0.10% interest on the cash posted.
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The 3 main financing risks are the increasing rates, widening spread,
and greater haircuts. The interest rates will increase if economic
conditions get worse because short term interest rates might
increase, making the roll-over strategy more costly. Next are widening
spreads, which will become an issue if yield spreads widen. If they
widen, KTC may receive a margin call from the broker and will need
to post up more capital. Finally are higher haircuts, the broker can
decide that KTC will need to post higher “haircuts” because KTC has
become too risky or unsure.
d. Give your views on the source of the yield differential that exists
and give an opinion whether Franey should try to exploit it. Is
the yield differential suggesting a potential arbitrage
opportunity or are there limits to arbitrage?
We know that yield differentials are differences in yields between 2
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bonds and they most likely occur due to liquidity in the market, time
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to maturity, and the risk of the security or bond. Liquidity affects yield
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spread in the difference between one that has been sold currently and
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one that has been traded for years. Maturity affects yield spread by
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offering a higher yield when maturity is longer. Lastly risk is
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correlated with higher yields, so the more risk you take the higher the
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yield. I think Franey should try to exploit this yield differential by
having a long position on Treasuries with higher yields and having a
short position on treasuries with lower yields.
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e. Assess the trade. Would you recommend putting the trade on?
How would you implement it?
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Yes, I would recommend putting the trade on using the tactic

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explained in part c. Part c explains how the trade will be implemented

in the long and short positions. The only capital required from this
trade is for the “haircuts” and it has an arbitrage opportunity of 1.8%
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with each trade.

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2. Short-answer questions:
a.) If the yield curve includes investors’ expectations, then a
positively sloped yield curve would reflect what type of
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expectation about future interest rates?

They would reflect higher interest rates in the future.
b.) If the yield curve includes investors’ expectations, then a
negatively sloped yield curve would reflect what type of
expectation about future interest rates?
In this case, the market would expect interest rates to be lower in the
future.
c.) What impact would an economic expansion have on default

risk premiums?
The default risk premium would become more narrow because
investors would be more confident to invest. This would cause them to
increase their investments in lower grade bonds.
d.) What would the discount rate on risky bonds be if the market
were risk neutral?
If the market were risk-neutral, the risk premium would be zero
because the rates on risky investments would equal to the risk-free
rate. Therefore, the risk-free rate would be the discount rate for risky
bonds in a market where its risk neutral.
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e.) How is an implied forward rate used as a cutoff rate?
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Expected rates for bonds during a specific period is equal to the
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current rate if expected rates are equal to implied forward rates.
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Therefore, if investors expect a future rate to be less than the
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applicable implied forward rate, then the expected holding period
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would be greater than the current rates. This mean the implied
forward rates can be used as a cutoff rate in assessing and choosing
bonds.
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f.) Explain how the YTM on many municipal bonds that are
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subject to default have historically been less than the YTM on

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T-bonds that are default free.

Municipals are tax-exempt causing them to trade at lower before-tax
YTM than other bonds that can be taxed.
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g.) Define the preferred habitat theory.

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States that investors and borrowers will move away from their
preferred maturity segment if the rates provide enough incentive
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to compensate them for giving up their preferences.

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3. Calculate Macaulay’s duration, the modified duration, and the

convexity of the following bonds (annualize the parameters).
Assume all of the bonds pay principal at their maturity.
a.) Four-year, 9% coupon bond with a principal of $1,000 and
annual coupon payments trading at par.
Macaulay’s duration: 3.53
Modified duration: 3.24
Convexity: 14.22
b.) Four-year, zero-coupon bond with a principal of $1,000 and

priced at $708.42 to yield 9%.

Convexity: 16.83
c.) Five-year, 9% coupon bond with a principal of $1,000 and

annual coupon payments trading at par.
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Convexity: 20.18
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d.) Ten-year, 7% coupon bond with a principal of $1,000 and
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semi-annual coupon payments (3.5%) and priced at par.

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Convexity: 120.32
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e.) Three-year, 7% coupon bond with a principal of $1,000 and

semi-annual coupon payments (3.5%) and priced at par.
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Convexity: 16.38
f.) Three-year zero-coupon bond with a principal of $1,000 and

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priced at $816.30 to yield 7%.

Convexity: 10.48
4. Given your duration and convexity calculations in question 2
above, answer the following:
a. Which bond has the greatest price sensitivity to interest
rate changes?
The 10 year bond will have the greatest price sensitivity to interest
rate changes due to having the largest duration value.
b. For an annualized 1% decrease in rates what would be the
approximate percentage change in the prices of bond d and
bond e?
Approximate changes to bond d would be changed to 7.35%

As for bond e, the change will be to 2.76%
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c. Which bond has the greatest non-symmetrical capital gain
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and capital loss feature?
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The bond with the greatest non-symmetrical capital gain and capital
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loss feature is bond d
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d. If you were a speculator and expected yields to decrease in
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the near future by the same amount across all maturities (a
parallel downward shift in the yield curve), which bond
would you select?
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I would select bond d.

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e. If you were a bond portfolio manager and expected yields

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to increase in the near future by the same amount across

all maturities (a parallel upward shift in the yield curve),
which bond would you select?
ed d
In this case, I would select bond e.

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f. Comment on the relation between maturity and a bond’s

price sensitivity to interest rate changes.
The relationship between maturity and a bond’s price sensitivity to
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interest rate changes is that the greater the maturity of a bond, the
more sensitive the price of the bond will be to changes in interest
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rate.
g. Comment on the relation between coupon rate and a

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bond’s price sensitivity to interest rate changes.

The relationship between the coupon rate and a bond’s price
sensitivity to interest rate changes is that the higher the coupon
bonds, the less bond price sensitivity there is to interest rate
changes.
5. What is tracking error? Explain why backward-looking tracking
error has limitations for estimating a portfolio’s future tracking
error.
Tracking error is the measure that represents divergence between the
return of the security and the index of the market. This is also called
active risk and is used when an indexing strategy is used by the
manager.
A portfolio’s backward looking tracking error is based on active
returns and shows the portfolio manager’s decisions during the period
along with the factors that affect tracking error. One limitation is that
it does not reflect how current decision by the portfolio manager will
affect future active returns and the future tracking error that may be
realized. Also, the backward looking tracking error will not be able to
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predict the market and can be misleading when taking risks in the
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future.
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6. What are the limitations of using duration and convexity
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measures in active portfolio strategies?
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Duration is classified as the number of years until the investor will
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receive the present value of the income from their investments.
Therefore, duration measures interest rate sensitivity.
Convexity is the measure of curvature that calculates the price
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fluctuations of a bond in relation to the interest rate fluctuations.

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Therefore, convexity measures the changes in duration of a bond with

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a change in interest rates.

The limitations that occur in active portfolio strategies include the
following:
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One limitation is that interest rate fluctuations cannot be accurately

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predicted. Due to them being unpredictable, duration and convexity

are no use because they measure the degree of sensitivity related to
interest rate fluctuations. This was seen recently during the corona
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virus pandemic when interest rates dropped to zero, something many

people did not see coming.
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Another limitation is that a client can limit the degree to which the
duration of the portfolio can say from the indicated index.
Another limitation is having a portfolio with different assets that have
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different maturities. When using duration as a measure of how the

portfolio value will change if market yields change is that the yield on
all the maturities will change by the same number of basis points. So,
two assets with the same duration may perform differently as the yield
curve changes.
7. Explain the difference in bond indexing using the full-replication
approach and a sample approach.
So the purpose of both the bond indexing approach and full-

replication approach is to buy all of the bonds found in the index in
the same proportion they are in the index. With this approach, there
will be a perfect correlation between the bonds in the fund and the
index.
On the other hand, a sample approach uses a smaller portfolio that is
highly correlated with the targeted index. The transaction costs to
build the index fund with this approach is less than the full-replication
approach because there are less bonds bought, resulting in less than
perfect correlation. Lastly, the differences between the returns on the
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index and the index fund are known as tracking errors.
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1F528 Fixed Income Investments

1. Questions from the case study: “Fixed income Arbitrage in

bond he bought +accrual $23.68 for a total of $1441.96, he would sell

return with no initial investments from KTC’s capital.

c. How might the trade be financed? Give an explanation of the

come from KTC and the 10.625% bonds will be collateral.

Yes, I would recommend putting the trade on using the tactic

explained in part c. Part c explains how the trade will be implemented

with each trade.

expectation about future interest rates?

c.) What impact would an economic expansion have on default

subject to default have historically been less than the YTM on

T-bonds that are default free.

g.) Define the preferred habitat theory.

to compensate them for giving up their preferences.

3. Calculate Macaulay’s duration, the modified duration, and the

b.) Four-year, zero-coupon bond with a principal of $1,000 and

Macaulay’s duration: 4.0

c.) Five-year, 9% coupon bond with a principal of $1,000 and

Macaulay’s duration: 7.35

Modified duration: 6.87

e.) Three-year, 7% coupon bond with a principal of $1,000 and

Macaulay’s duration: 2.76

f.) Three-year zero-coupon bond with a principal of $1,000 and

priced at $816.30 to yield 7%.

Macaulay’s duration: 3.0

Approximate changes to bond d would be changed to 7.35%

I would select bond d.

e. If you were a bond portfolio manager and expected yields

to increase in the near future by the same amount across

In this case, I would select bond e.

f. Comment on the relation between maturity and a bond’s

g. Comment on the relation between coupon rate and a

bond’s price sensitivity to interest rate changes.

fluctuations of a bond in relation to the interest rate fluctuations.

Therefore, convexity measures the changes in duration of a bond with

a change in interest rates.

One limitation is that interest rate fluctuations cannot be accurately

predicted. Due to them being unpredictable, duration and convexity

virus pandemic when interest rates dropped to zero, something many

different maturities. When using duration as a measure of how the

So the purpose of both the bond indexing approach and full-

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