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Fixed Income : Valuation and Analysis

Christophe Dispas
Fundamentals

What is a bond?

Fundamentals  Debt of a borrower (issuer) towards a lender (bondholder)

 Financial obligation
Time Value of
Money
 Stream of future cash flows :
 Interest payments
 Principal repayment
 Principal : legal structure different from its coupons
Fixed Income
Portfolio  Bond indenture
Management
Strategies
 Any assets a prior claim of creditors?
 Garantees and commitments?

Fixed Income : Valuation and Analysis- 2


Fundamentals
Coupon and principal

 Name – Coupon – Maturity


Fundamentals
 Face value :
 Total amount repaid at maturity
 Used to determine coupon payments
Time Value of
Money  Time to maturity

 Maturity date

Fixed Income  Coupon payment : coupon rate x face value


Portfolio
Management
 Annually, semi-annually, …
Strategies
 Legal differences : expected return pre tax and after
tax

Fixed Income : Valuation and Analysis- 3


Fundamentals

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 4


Fundamentals

Price quotes

Fundamentals  Market value

 Percentage of the face value


 US : in 32nds of a percent
Time Value of  Size of minimum price change
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 5


Fundamentals

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 6


Fundamentals

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 7


Fundamentals

Accrued interest

 To compare bonds => Clean price


Fundamentals
 Clean price = net of interest

 Buy or Sell : pro-rata basis of the coupon added to the


Time Value of
Money
clean price

 Dirty price = clean price + accrued interest

Fixed Income  Accrued interest =


Portfolio
Management
Principal x (Coupon rate/Nr. Coupons per year) x fractional coupon period
Strategies

Fixed Income : Valuation and Analysis- 8


Fundamentals
Accrued interest : use the right conventions
Coupon Frequency Accrued Interest

Government Bonds
Fundamentals USA Semi-annual Actual/Actual

Japan Semi-annual Actual/365

UK Semi-annual Actual/Actual

France Annual Actual/Actual

Germany Annual Actual/Actual


Time Value of
Netherlands Annual Actual/Actual
Money
Canada Semi-annual Actual/365

Australia Semi-annual Actual/Actual

Italy Semi-annual Actual/Actual

Corporate Bonds
Fixed Income USA Annual or Semi-annual 30/360
Portfolio
Management UK Semi-annual Actual/365 or
Actual/Actual *
Strategies

Eurobonds
Issued Annual 30/360
before 1/1/99 (some Semi-annual)
Issued Annual Actual/Actual
after 31/12/99 (some Semi-annual)

Fixed Income : Valuation and Analysis- 9


Fundamentals
Types of fixed income securities

 Straight bond
 Interest payments periodically
Fundamentals
 Principal at maturity

 Sinking-fund provision
Time Value of
 Sinker percentage : retire a portion of the
Money outstanding debt (sinker percentage), each year

 Callable bonds
 Issuer has the right to repurchase the bond at
Fixed Income call price, at call date
Portfolio
Management
 Protect issuer if interest rate drop
Strategies

Fixed Income : Valuation and Analysis- 10


Fundamentals
Types of fixed income securities

 Putable bonds : bondholder has the right


Fundamentals
 Bullet bonds : bonds that cannot be redeemed prior to
maturity

Time Value of
 Perpetual bonds : principal never redeemed
Money
 Zero-coupon bonds :
 Do not pay any interest
 Generally issued at large discount to the face value
Fixed Income
Portfolio
Management
 Stripped bonds :
Strategies  Zero-coupon bonds
 Artificially created from default risk free
government bonds

Fixed Income : Valuation and Analysis- 11


Fundamentals
Types of fixed income securities

 Income bonds :
 Pays interest only if profits of the issuing firm are
Fundamentals
adequate enough to pay interest
 A missed coupon is not a default
 Cumulative / non-cumulative
Time Value of
Money  Floating rate notes :
 Coupon adjusted periodically
 Depend on a base or benchmark rate

Fixed Income  Dual currency bonds :


Portfolio
Management
 Interest paid in one currency, principal in another
Strategies  Foreign interest payment securities
 Multiple currency clause bonds

Fixed Income : Valuation and Analysis- 12


Fundamentals

Types of fixed income securities

 Convertible bond :
Fundamentals  The holder can exchange the security for shares of
the company
 Terms set in the bond indenture (number of
shares, …)
Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 13


Fundamentals
4 types of bonds based on the issuer :

 Domestic bonds :
 Domestic issuer
Fundamentals
 Usually in local currency

 Foreign bonds :
Time Value of
 Foreign issuer
Money  Local market
 Usually local currency

 Eurobonds :
Fixed Income  Multinational syndicate
Portfolio
Management
 All countries other than the one in whose currency
Strategies the bond is denominated
 Trade in the international marketplace

 Global Bonds
Fixed Income : Valuation and Analysis- 14
Fundamentals

Money market instruments :

Fundamentals  Short term debt securities

 Maturities up to 12 months

Time Value of  Liquid


Money

 Very large denominations

Fixed Income  Interest earned expressed on the bank discount basis


Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 15


Fundamentals

Money market instruments :

Fundamentals  Treasury bills

 Discount with respect to the face value

Time Value of  Interest = face value – purchase price


Money

 Competitive auction : bid is filled if price entered is


high enough (relative to other participants’ bid)
Fixed Income
Portfolio  Non-competitive auction : price is equal for all the
Management
Strategies
subscribers (marginal price or average price)

 Interest rate and credit risk very low

Fixed Income : Valuation and Analysis- 16


Fundamentals

Money market instruments :

 Commercial paper
Fundamentals

 Short term unsecured debt

 Issued by large and well-known companies


Time Value of
Money
 Usually guaranteed by a bank line of credit

 Rating
Fixed Income
Portfolio  Most frequent maturities : 1 or 2 months
Management
Strategies
 Source of funds cheaper than the ordinary bank
borrowing

Fixed Income : Valuation and Analysis- 17


Fundamentals

Money market instruments :

 Bankers’ acceptance
Fundamentals

 Commercial bills of exchange whose credit risk


has been guaranteed by a bank
Time Value of
Money  Traded at a discount

 Accepting institution is obligated to pay

Fixed Income The bank receive a fee


Portfolio
Management
Strategies  Usually less risky than commercial paper

Fixed Income : Valuation and Analysis- 18


Fundamentals

Money market instruments :

 Certificate of deposit (CD)


Fundamentals

 Time deposit with a bank

 Usually a given period of time


Time Value of
Money
 Usually a fixed rate of interest, paid at maturity

 Cannot be withdrawn, but can be sold over the


Fixed Income secondary market
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 19


Fundamentals

Government bonds :

 Maturity higher than 1 year


Fundamentals

 US Government bonds :

 Treasury notes : up to 10 years


Time Value of
Money  Treasury bonds : 10 to 30 years
 Semi-annual coupon payments
 Government guaranteed : low credit risk
 Circulation is managed by Central Bank book-entry
Fixed Income form : no physical circulation
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 20


Fundamentals

Corporate securities

 Issued by private and public corporations


Fundamentals

 Usually, interest payments are semi-annual

 Bond indenture can be very specific and complex


Time Value of
Money
 Up to 10 years : notes; Over 10 years : bonds

 Classification based on the nature of the issuer :


Fixed Income traditional classification is sectorial
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 21


Fundamentals

Corporate securities
Fundamentals
 Credit quality :
 Offer document
 Ratings
Time Value of
Money  Protection :
 Mortgage bonds
 Collateral trust bonds
 Senior claim
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 22


Fundamentals
Corporate securities

 Debenture bond : recovery rate is the same as general


creditors’ one (the claim is junior)
Fundamentals
 Subordinated debenture bonds :
 Rank after secured bonds in claim on corporate
earnings and assets
Time Value of
Money  Difference in protection = difference in yield

 Secured => ordinary => subordinated

Fixed Income  Call provision


Portfolio
Management
Strategies  Sinking funds :
 Control the credit risk
 Balloon payment : amount remaining
 Accelerated sinking fund
Fixed Income : Valuation and Analysis- 23
Fundamentals

Indices

 General price performance of a group of bond issues


Fundamentals

 Broad-based market indices or sub-segments

 Brokers publish indices to sell tracking and


Time Value of
Money rebalancing services to investors

 Total return indices

Fixed Income  Non liquid bonds : fair price


Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 24


Fundamentals
Indices

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 25


Fundamentals
Indices

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 26


Fundamentals
Indices

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 27


Time value of money

 Present is certain, future not => to differ consumption


requires incentive : interest rate
Fundamentals
 Simple vs compound interest

 Simple interest = (initial value) . (interest rate) . (Nbr of years)


 Hypothesis : interest payments are not reinvested
Time Value of
Money
 Compound interest

 Interest is reinvested
Fixed Income  Compound interest =
Portfolio
Management
Strategies (initial amount) . [(1+ interest rate)nbrofyears - 1]

Fixed Income : Valuation and Analysis- 28


Time value of money

 Simple interest
Fundamentals

Time Value of
Money
 Compound interest

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 29


Time value of money

 Simple interest
Fundamentals

Time Value of
1000 EUR . 0,07 . 10 = 700 EUR
Money

 Compound interest
Fixed Income
Portfolio
Management
Strategies

1000 EUR . [(1+ 0,07)10 - 1] = 967,15 EUR

Fixed Income : Valuation and Analysis- 30


Time value of money

Present and future value

 Present value of future payment : discounting


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 31


Time value of money

Present and future value

 Present value of future payment : discounting


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 32


Time value of money

Present and future value

 Future value of a payment : compounding


Fundamentals

Time Value of
Money  Example :

100 000 EUR deposited in a bank account with 5%


Fixed Income
annual interest rate
Portfolio
Management End year 1 : 100 000 EUR . (1+ 0,05) = 105 000 EUR
Strategies
End year 2 : 105 000 EUR . (1 + 0,05) = 110 250 EUR

Equals : 100 000 EUR . (1+0,05)2


Fixed Income : Valuation and Analysis- 33
Time value of money

Present and future value

 High interest rate and long investment period lead to


Fundamentals
greater accumulation of compound interest

Example
Time Value of
Money
 1000 EUR, interest rate = 10,5%, 67 years

Fixed Income Simple interest : 1000 EUR + (1000 EUR . 0,105 . 67) = 8 035 EUR
Portfolio
Management
Strategies
Compound interest : 1000 EUR . (1+0,105)67 = 804 030,69 EUR

Fixed Income : Valuation and Analysis- 34


Time value of money
Annuities

 Fixed amount paid each year for a specified number of


years
Fundamentals

 Hypothesis :

Time Value of
First payment is received one year from now
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 35


Time value of money

Annuities

 Present value
Fundamentals

Time Value of
Money
 Future value

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 36


Time value of money

Annuities

 Future value
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 37


Time value of money

Continuous discounting and compounding

 Compounding can take place more than annually


Fundamentals

 Initial amount N invested at a rate R during n years :

Time Value of
Money
 When m tends to infinity :

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 38


Time value of money

Continuous discounting and compounding

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 39


Time value of money

Continuous discounting and compounding

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 40


Time value of money

Bond yield measures

 Current yield
Fundamentals

Time Value of
Money

 The price is the clean price


 Bond’s current yield varies inversely with the
Fixed Income bond’s price
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 41


Time value of money
Bond yield measures

 Current yield
Fundamentals
 Not adequate to compare bonds

 Current yield of a zero-coupon bond is zero


Time Value of  Current yield of a bond under par decrease as
Money the bond approaches maturity

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 42


Time value of money

Bond yield measures

 Yield to maturity
Fundamentals
 Discount rate that equals present value of future
cash flows and market price :

Time Value of
Money

Fixed Income
 Internal rate of return (IRR) of the investment in the
Portfolio bond
Management
Strategies

Fixed Income : Valuation and Analysis- 43


Time value of money

Bond yield measures

 Yield to maturity
Fundamentals

Time Value of
Money

Fixed Income  Assumes bond is held to maturity


Portfolio
Management
 Cash flows are received as scheduled
Strategies  YTM is not the total return of a bond

Fixed Income : Valuation and Analysis- 44


Time value of money

Bond yield measures

 Yield to maturity
Fundamentals

 From semi-annual to annual yield :

Time Value of
Money

 On a Euromarket :
Fixed Income
Portfolio
Management
Strategies
 On the US or English market :

Fixed Income : Valuation and Analysis- 45


Time value of money

Bond yield measures

 Yield to maturity
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 46


Time value of money

Bond yield measures

 Yield to maturity
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies  With annual coupon : 4.72%

Fixed Income : Valuation and Analysis- 47


Time value of money

Bond yield measures

 Yield to maturity between two coupon payment dates


Fundamentals

 Accrued interest
 Total price = Market price + f . Coupon
 Usually, f = (nbr of days between last coupon and
Time Value of
Money today / nbr total of days between the two coupons)

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 48


Time value of money

Bond yield measures

 Yield to maturity between two coupon payment dates


Fundamentals

 Adjusted formula :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 49


Time value of money

Yield to maturity

 Yield to maturity between two coupon payment dates


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies  NB :
 With a financial calculator, the clean price is used
to compute

Fixed Income : Valuation and Analysis- 50


Time value of money

Yield to maturity

 Yield to maturity between two coupon payment dates


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 51


Time value of money

Yield to maturity

 Influences on the yield to maturity : the coupon effect


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
=> Calculate bond prices
Strategies

Fixed Income : Valuation and Analysis- 52


Time value of money

Yield to maturity

 Influences on the yield to maturity : the coupon effect


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies => With these prices, calculate YTM

Fixed Income : Valuation and Analysis- 53


Time value of money

Yield to maturity

 Influences on the yield to maturity : the coupon effect


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies => YTM is an average of the spot rates

Fixed Income : Valuation and Analysis- 54


Time value of money

Yield to maturity

 Influences on the yield to maturity : the coupon effect


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies
⇒YTM is an average of the spot rates

Fixed Income : Valuation and Analysis- 55


Time value of money
Yield to maturity

 Influences on the yield to maturity : the coupon effect


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies
⇒ If R0,t are increasing, YTM will underestimate the
corresponding spot rate R0,T
Fixed Income : Valuation and Analysis- 56
Time value of money
Yield to maturity

 Influences on the yield to maturity : the coupon effect


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies
⇒ Bias increase for larger coupon rates

Fixed Income : Valuation and Analysis- 57


Time value of money
Yield to maturity

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 58


Time value of money

Bond yield measures

 Yield to call
Fundamentals

Time Value of
Money
 Assumes that the bond will be called
 Assumes that all cash flows are received as scheduled
through the call date
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 59


Time value of money

Bond yield measures

 Yield to call
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 60


Time value of money

Bond yield measures

 Yield to call
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies  Yield to call differs from yield to maturity
 Discounting period is shorter
 Final cash flow is generally higher

Fixed Income : Valuation and Analysis- 61


Time value of money

Bond yield measures

 Japanese current yield


Fundamentals

 Current yield adjusted for capital gain/losses :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 62


Time value of money
Bond yield measures

 Yield to average life

Fundamentals  Full principal repayment supposed to occur on the


average life date
 Useful to compare bonds with a series of principal
repayment with bullet bonds
Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 63


Time value of money

Bond yield measures

 Yield to average life


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 64


Time value of money

Bond yield measures

 Yield to average life


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

=> Comparable to bullet bond with maturity = AL

Fixed Income : Valuation and Analysis- 65


Time value of money

Bond yield measures

 Call-adjusted yield
Fundamentals

 To compare YTM of callable and non-callable


bonds
Time Value of
Money  Price of the non callable bond = price of the
callable bond + value of the call option

 Yield to call = YTM bullet bonds with maturity date


Fixed Income = call date
Portfolio
Management
Strategies  YTM callable bond = YTM bullet bond with price
adjusted for the price of the call

Fixed Income : Valuation and Analysis- 66


Time value of money
Bond yield measures

 Call-adjusted yield
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 67


Time value of money

Other basic concepts

Fundamentals  Dates essential while determining any rate of interest :

 Commitment date : fixed rate on the loan


 Lending date : money is to be loaned
Time Value of  Repayment date : money is to be repaid
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 68


Time value of money

Other basic concepts

Fundamentals  Spot rates :

 R0,t : Annual interest rate received on a zero


coupon bond maturing at t
Time Value of
Money
 ONE final payment for interest and principal

 Commitment date and lending date are the same


Fixed Income
Portfolio  Generally, spot rates are quoted as annual rates
Management
Strategies

Fixed Income : Valuation and Analysis- 69


Time value of money

Other basic concepts

Fundamentals  Spot rates :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 70


Time value of money

Other basic concepts

Fundamentals  Spot rates :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 71


Time value of money

Other basic concepts

Fundamentals  Forward rates :

 Ft,h : Rate of interest of a bond with commitment


date (0) different from lending date (t)
Time Value of
Money
 Pay only one cash flow

 Generally annual rates


Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 72


Time value of money

Other basic concepts

Fundamentals  Forward rates :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 73


Time value of money

Other basic concepts

Fundamentals  Forward rates :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 74


Time value of money

Other basic concepts

Fundamentals  Relation between spot rate and forward rate

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 75


Time value of money

Other basic concepts

Fundamentals  Relation between spot rate and forward rate

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 76


Time value of money

Other basic concepts

Fundamentals  Relation between spot rate and forward rate

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 77


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 78


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 79


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 80


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 81


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 82


Time value of money

Fundamentals

[ ( (1+4.2%)^4 ) / ( (1+4.1%)^3 ) ]-1


Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 83


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 84


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 85


Time value of money

Term structure of interest rates

Fundamentals
 Relationship between the yields on comparable bonds
with different maturities

Time Value of  Appreciation of the interest rate-maturity relationship


Money
is essential in bond management

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 86


Time value of money

Term structure of interest rates

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 87


Time value of money

Term structure of interest rates

 Problems in building term structure of interest rates


Fundamentals

 Use only zero-coupon bonds (reinvestment risk)

 Some rates are unavailable


Time Value of
Money
 Few corporates zero-coupon bonds

Fixed Income  Practical solution : yield curve


Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 88


Time value of money

Yield curve

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 89


Time value of money

Definitions

Fundamentals
 Term structure : relationship between spot rates and
time to maturity

Time Value of  Yield curve : relationship between yield to maturity and


Money time to maturity

=> To analyze maturity-return relationship, spot rates are


Fixed Income
Portfolio better
Management
Strategies

Fixed Income : Valuation and Analysis- 90


Time value of money

Definitions

Fundamentals  Nominal rate = real interest rate + inflation premium +


risk premium

 Real interest rate : compensation for deferring


Time Value of
Money
consumption

 Inflation premium : preserve investor’s purchasing


power over time
Fixed Income
Portfolio  Risk premium : protects investors against all other
Management
Strategies potential negatives

Fixed Income : Valuation and Analysis- 91


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 92


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 93


Time value of money

Risks should be (sufficiently) similar for useful yield curves :

Fundamentals  Liquidity risk

 Credit risk
Time Value of
 Call risk
Money

 Coupon rate

Fixed Income  Degree of premium/discount


Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 94


Time value of money
Term structure of interest rates : shapes

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 95


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 96


Time value of money
Term structure of interest rates : shapes

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

=> Short maturity : monetary policy; long maturity : inflationary expectations


Fixed Income : Valuation and Analysis- 97
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 98


Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis- 99


Time value of money

Theories of term structures

 Expectations hypothesis
Fundamentals
 Liquidity preference

 Market segmentation theory


Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


100
Time value of money
Theories of term structures

 Expectations hypothesis
Fundamentals
 Reflects market consensus forecast on future
interest rates levels

Time Value of  Implicit forward rate is an unbiaised estimate of the


Money future spot rate :

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


101
Time value of money
Theories of term structures

 Expectations hypothesis

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


102
Time value of money
Theories of term structures

 Expectations hypothesis

 If all investors choose a rollover strategy, prices


Fundamentals
should adjust

 If implicit forward rates are unbiaised estimate of


future spot rate :
Time Value of
Money ⇒ Without transaction costs, each bond is a
perfect substitute for any other bond, whatever its
maturity

Fixed Income
Portfolio  In this case, these 3 strategies are equivalent :
Management
Strategies
 Buy and hold strategy
 Rollover strategy
 Buy a bond and sell it prior to maturity
Fixed Income : Valuation and Analysis-
103
Time value of money
Theories of term structures

 Expectations hypothesis
Fundamentals
 Explains the slope of the curve : slope = expectation
of rates

Time Value of  Assumptions of this theory :


Money
 Homogenous expectations
 Investors choose between short and long-term
bonds in order to maximise their final expected
Fixed Income
Portfolio
wealth for a given investment period
Management  No transaction costs
Strategies  Bond markets are efficients

Fixed Income : Valuation and Analysis-


104
Time value of money

Theories of term structures

 Expectations theories
Fundamentals
 Naive expectations hypothesis :
 Expected returns for any strategy for any
holding period are equal
Time Value of
Money
 Local expectations :
 Refers only to total returns over a (short) period
beginning at the present
Fixed Income
Portfolio  Unbiased expectations :
Management
 Forward rates equals future EXPECTED spot
Strategies
rates

Fixed Income : Valuation and Analysis-


105
Time value of money

Theories of term structures

 Expectations theories
Fundamentals

 Return to maturity expectations :


 Expected return of holding a bond up to maturity
has to be equal to the expected return we would
Time Value of
Money obtain by rolling over a sequence of single-period
bonds over the same horizon

 Yield to maturity version :


Fixed Income  This version deals with periodic returns, while
Portfolio
Management
return to maturity version is concerned with total
Strategies returns over the investment horizon

Fixed Income : Valuation and Analysis-


106
Time value of money
Theories of term structures

 Expectations theories

 In Cox, Ingersoll and Ross (1981) :


Fundamentals

 Only local expectations theory is consistant


with an equilibrium (arbitrage profits for the
Time Value of
others)
Money  The remaining four versions are not equivalent
or consistant with each other with UNCERTAIN
interest rates

Fixed Income  Inconsistency of the naive expectations theory


Portfolio
Management hypothesis
Strategies
 Relation derived for a one year period is
inconsistant with relation derived for a two year
period under the naive expectations hypothesis
Fixed Income : Valuation and Analysis-
107
Time value of money
Theories of term structures

 Liquidity preferences
Fundamentals
 In expectation theory, investors don’t have maturity
preference

Time Value of  Liquidity preference theory : investors prefer to hold


Money liquid securities

 Liquidity = convert a bond into cash, minimising the


loss
Fixed Income
Portfolio
Management  Fluctuation risk is higher for long term bonds 
Strategies investors prefer short term securities

Fixed Income : Valuation and Analysis-


108
Time value of money
Theories of term structures

 Liquidity preferences
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


109
Time value of money

Theories of term structures

 Liquidity preferences
Fundamentals
 Borrowers prefer to issue long to avoid interest
rates fluctuations

Time Value of  Liquidity premium or term premium


Money
 Two factors in the observed term structure of interest
rates :
 Future expected short term spot rates
Fixed Income
Portfolio  A positive liquidity premium
Management
Strategies

Fixed Income : Valuation and Analysis-


110
Time value of money
Theories of term structures

 Liquidity preferences

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


111
Time value of money
Theories of term structures

 Liquidity preferences

Fundamentals

Time Value of
Money
 Expected return on buy and hold strategy has to be
higher than the expected return on a rollover strategy

Fixed Income  Liquidity premium increase with time


Portfolio
Management
Strategies
 Term structure of interest rate should be mainly upward
sloping

Fixed Income : Valuation and Analysis-


112
Time value of money

Theories of term structures

 Market segmentation and preferred habitat theories


Fundamentals
 Bond markets : distinct markets that differ by their
maturity

Time Value of  Issuer and investors have a preferred maturity,


Money
and sufficiently risk-averse to operate ONLY in this
spectrum

Fixed Income  Supply and demand determine the price in the


Portfolio maturity range
Management
Strategies

Fixed Income : Valuation and Analysis-


113
Time value of money
Theories of term structures

 Market segmentation and preferred habitat theories


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


114
Time value of money

Theories of term structures

 Market segmentation and preferred habitat theories


Fundamentals
 Risk premium can be positive, negative or zero

Time Value of
Money

 Market clearing price is the interest rate


Fixed Income
Portfolio  Term structure of interest rates : supply and
Management
Strategies demand of each individual segments

 Flow of funds in the market segments could predict


changes in the term structure of interest rates
Fixed Income : Valuation and Analysis-
115
Time value of money

Theories of term structures

 Market segmentation and preferred habitat theories


Fundamentals

 Explains the four basic term structure :

 Positively sloped : preference for the short term


Time Value of
Money
 Negatively sloped : preference for the long term

 Flat : similar preferences


Fixed Income
Portfolio  Humped : different preferences for different
Management
Strategies maturities

Fixed Income : Valuation and Analysis-


116
Time value of money

Theories of term structures

 Market segmentation and preferred habitat theories


Fundamentals
 Limits :

 Relative yields should push investors change of


Time Value of
segment for a sufficiently higher yield
Money

 Investor should quit preferred habitat if risk


premium is high enough to cover risks and costs
Fixed Income leaving it
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


117
Time value of money

Theories of term structures

Fundamentals  Stochastic process no-arbitrage approaches

 Term structure and bond prices are related to some


stochastic factors
Time Value of
Money  Factors evolves over time according to a particular
hypothesized stochastic process

 No arbitrage opportunity
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


118
Time value of money

Theories of term structures

Fundamentals  Stochastic process no-arbitrage approaches

 Example : Ogden model (1987)

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


119
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


120
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


121
Time value of money

Bond price analysis

 Yield spread analysis


Fundamentals
 Yield spread : differential in the yields of two or more
bonds

 Yield spread analysis : causes and consequences of


Time Value of
Money those spreads

 Usually measured against the yield of a treasury


security having comparable maturity
Fixed Income  Highest quality in marketability, credit risk and,
Portfolio
Management
often, tax status
Strategies
 Spread = risk premium

 Spreads : measured in basis points (1bp = 0,01%)


Fixed Income : Valuation and Analysis-
122
Time value of money
Bond price analysis

 Yield spread analysis

Fundamentals  Relative yield spread

Time Value of
Money

 Yield ratio
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


123
Time value of money
Bond price analysis

 Yield spread analysis

Fundamentals  Types of spreads :

 Type of issuer (Treasury, Corp, financial)


 Credit quality (Rating)
Time Value of  Maturity
Money
 Coupon

 Determinants of yield spreads :


Fixed Income
Portfolio  Maturity
Management
Strategies
 Credit
 Embedded options
 Tax status
 Liquidity
Fixed Income : Valuation and Analysis-
124
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


125
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


126
Time value of money

Bond price analysis

 Yield spread analysis


Fundamentals
 Determinants of yield spreads :

 Credit
Time Value of
Money  Probability of default

 Expected yield lower than promised yield


Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


127
Time value of money
Bond price analysis

 Yield spread analysis

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


128
Time value of money
Bond price analysis

 Yield spread analysis

Fundamentals  Credit spread :

 Tend to widen when the economy is likely to face


recession
Time Value of
Money
 Higher probability of default in recession

 Lower recovery rate


Fixed Income
Portfolio  Formula (p=probability of total payment)
Management
Strategies

Fixed Income : Valuation and Analysis-


129
Time value of money
Bond price analysis

 Yield spread analysis


Fundamentals
 Credit spread :

Time Value of  Formula with recovery rate :


Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


130
Time value of money

Bond price analysis

 Yield spread analysis


Fundamentals
 Embedded options

 Options benefits the party who can choose to


Time Value of
exercise it => yield differential
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


131
Time value of money

Bond price analysis

 Yield spread analysis


Fundamentals
 Tax status

 Net income matters for investors


Time Value of
Money  Taxable bond has to pay higher yield to
compete with an exempt bond

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


132
Time value of money

Bond price analysis

 Yield spread analysis


Fundamentals
 Tax status

Time Value of  To compare taxable and non taxable bonds :


Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


133
Time value of money

Bond price analysis

 Yield spread analysis


Fundamentals
 Liquidity

 The greated the expected liquidity, the lower


Time Value of the required yield
Money
 Marketability : broad and deep market

 Time to maturity : at maturity, cash


Fixed Income
Portfolio
Management  Financiability : the issue can be liquid, but is
Strategies
utilized as a collateral to borrow funds

Fixed Income : Valuation and Analysis-


134
Time value of money
Bond price analysis

 Bond valuation
Fundamentals
 Discounted cash flow method

 Equilibrium concept
Time Value of
Money

Fixed Income
Portfolio
Management
Strategies Example : ZC bond, pay 1000 EUR in 5 years,
discount rate = 7%; 7 year bond ?

Fixed Income : Valuation and Analysis-


135
Time value of money
Bond price analysis

 Bond valuation
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


136
Time value of money

Bond price analysis

 Bond valuation
Fundamentals
 Generally, discount rate varies from maturity to
maturity

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


137
Time value of money
Bond price analysis

 Bond valuation
 Static arbitrage and valuation of coupon bonds
Fundamentals
 A coupon-bearing bond can be visualised as a
portfolio of zero-coupon bonds

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


138
Time value of money
Bond price analysis

 Bond valuation

Fundamentals  Static arbitrage and valuation of coupon bonds

 A coupon-bearing bond can be visualised as a


portfolio of zero-coupon bonds
Time Value of
Money  Bond price = price of replicating ZC bond
portfolio

Fixed Income
Portfolio
Management
Strategies

 If the final repayment is not made at par, only the


final cash flow is modified
Fixed Income : Valuation and Analysis-
139
Time value of money

Bond price analysis

 Bond valuation
Fundamentals
 Static arbitrage and valuation of coupon bonds

 Semi annual coupon : same formula but :


Time Value of
Money  CFt = cash flow received at the end of the
SEMI-ANNUAL period (ex : 2% on a 4%
coupon)
Fixed Income
Portfolio  R = required rate of the SEMI-ANNUAL
Management period
Strategies

 T : nbr of years x 2

Fixed Income : Valuation and Analysis-


140
Time value of money
Bond price analysis

 Bond valuation
Fundamentals
 Static arbitrage and valuation of coupon bonds

 Floating rate bonds :


Time Value of
Money  New coupon = market spot rate for the
next period

 After the coupon payment, bond should


Fixed Income
Portfolio
be at par
Management
Strategies  Short term zero coupon with maturity =
next coupon payment (sell the bond at 100)

Fixed Income : Valuation and Analysis-


141
Time value of money
Bond price analysis

 Bond valuation
Fundamentals
 Static arbitrage and valuation of coupon bonds

 Floating rate bonds :


Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


142
Time value of money
Bond price analysis

 Bond valuation

Fundamentals  Static arbitrage and valuation of coupon bonds

 Floating rate bonds :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


143
Time value of money
Bond price analysis

 Bond valuation

Fundamentals  Static arbitrage and valuation of coupon bonds

 Floating rate bonds :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


144
Time value of money
Bond price analysis

 Bond valuation
Fundamentals
 Static arbitrage and valuation of coupon bonds

 Floating rate bonds :


Time Value of
Money  Coupon rate not always equal to the market
spot rate for the next period

 Default risk
Fixed Income
Portfolio  Announcement of the next coupon rate not
Management
Strategies always on the previous-coupon payment date

Fixed Income : Valuation and Analysis-


145
Time value of money
Bond price analysis

 Bond valuation

Fundamentals  Static arbitrage and valuation of coupon bonds

 The impact of the coupon rate

Time Value of  Higher coupon will be worth more than a


Money
lower coupon issue with the same maturity

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


146
Time value of money
Bond price analysis

 Bond valuation

Fundamentals  The impact of the discount rate of interest

 Bond price inversely related to the


discount rate of interest
Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


147
Time value of money
Bond price analysis

 Bond valuation

 Strips markets
Fundamentals

 Separately Traded Registered Interest and


Principal
Time Value of
Money  Zero coupon notes

 Example : Treasury with 10 years to maturity :

Fixed Income  20 zero-coupon from 6 mths to 10 years


Portfolio
Management
 One 10 year zero coupon
Strategies
 Created by financial institutions

Receive a prespecified sum at a prespecified date


Fixed Income : Valuation and Analysis-
148
Time value of money

Bond price analysis

 Price / yield relationship


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


149
Time value of money
Bond price analysis

 Price / yield relationship

Fundamentals  Current yield : focuses solely the coupon return

 Yield to maturity :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


150
Time value of money
Bond price analysis

 Price / yield relationship


Fundamentals
 Yield to maturity : proxy for total return if

 All coupon reinvestment at YTM (in reality at


market rate)
Time Value of
Money
 Reinvestment rate risk : long term bonds, high
coupon rate

Fixed Income  If sold before maturity, market rate must = YTM


Portfolio
Management
Strategies  YTM must be expressed in annual equivalent

 Equivalence of YTM and total return not


supported by theory
Fixed Income : Valuation and Analysis-
151
Time value of money
Bond price analysis

 Price / yield relationship


Fundamentals
 Yield to maturity vs total return :

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


152
Time value of money
PRICING

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


153
Time value of money
PRICING

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


154
Time value of money
TERM STRUCTURE OF INTEREST RATES

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


155
Time value of money
TERM STRUCTURE OF INTEREST RATES

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


156
Time value of money
Risk measurement

 Bond return : change in price + cash flows + reinvestment


Fundamentals
 Risk of a bond : impact of market factors on return
characteristics

Time Value of  Systematic risk : volatility in total bond return due to


Money interest rate fluctuation

 Increasing interest rate volatility : bond from safe to risky

Fixed Income  Price risk : sell a bond prior to the maturity date
Portfolio
Management
Strategies  Reinvestment risk

 Price risk and reinvestment risk act in opposite directions


Fixed Income : Valuation and Analysis-
157
Time value of money
Risk measurement

 Instantaneous change in the bond’s yield

Fundamentals  Long maturity bonds are more sensitive

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


158
Time value of money
Risk measurement

 Instantaneous change in the bond’s yield

Fundamentals  Long maturity bonds are more sensitive

 Same relationship if rates decrease

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


159
Time value of money
Risk measurement

 Instantaneous change in the bond’s yield

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


160
Time value of money
Risk measurement

 Instantaneous change in the bond’s yield

Fundamentals  Low coupon bonds are more volatile

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


161
Time value of money
Risk measurement

 Instantaneous change in the bond’s yield

Fundamentals  Low yield bonds are more volatile

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


162
Time value of money
Risk measurement

 Instantaneous change in the bond’s yield


Fundamentals
 Bond with sinking fund provision less volatile

 Callable bonds are less volatile


Time Value of
Money  Price volatility is not a symmetric phenomenon

Current market yield : 6%

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


163
Time value of money

Risk measurement

 Risk measurement tools


Fundamentals
 Time to maturity

 Number of years until bond’s final maturity date


Time Value of
Money
 Long maturity bonds riskier

 Wait longer to recover principal


Fixed Income  More sensitive to interest rate fluctuations
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


164
Time value of money
Risk measurement

 Risk measurement tools

Fundamentals  Time to maturity

 Weak risk tool


 Cash flows prior to final maturity
Time Value of  Linear relationship between time to maturity
Money
and price volatility

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


165
Time value of money
Risk measurement

 Risk measurement tools

Fundamentals  Weighted average maturity (average life)

Time Value of
Money

 Only considers principal repayments


Fixed Income
Portfolio  Identical to time to maturity for bullet bonds
Management
Strategies
 Better for Sinking requirement and MBS

 Insensitive to the coupon differentials


Fixed Income : Valuation and Analysis-
166
Time value of money
Risk measurement

 Risk measurement tools

Fundamentals  Weighted average cash flow

Time Value of
Money

 Repayments are considered on a nominal basis


Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


167
Time value of money
Risk measurement

 Risk measurement tools

Fundamentals  Duration and modified duration

 Average time at which the cash flow occur

Time Value of  Present value of each cash flow


Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


168
Time value of money
Risk measurement

 Risk measurement tools

Fundamentals  Duration and modified duration

 Duration (Macaulay’s duration) is mesured in


years
Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


169
Time value of money
Risk measurement

 Risk measurement tools

Fundamentals  Duration and modified duration

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


170
Time value of money
Risk measurement

 Risk measurement tools

Fundamentals  Duration and modified duration

 Duration of a ZC = maturity

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


171
Time value of money

Risk measurement

 Risk measurement tools


Fundamentals
 Duration and modified duration

 Different coupon frequency, sinking fund


Time Value of requirements : same methodology
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


172
Time value of money
Risk measurement

 Duration and modified duration


Fundamentals
 Interpretations

 Takes into account :


Time Value of
Money  Cash flows
 YTM
P

Fixed Income  Coupon-bearing bond and ZC maturing on the


Portfolio
Management
duration date of the coupon bearing issue
Strategies

Fixed Income : Valuation and Analysis-


173
Time value of money
Risk measurement

 Duration and modified duration

Fundamentals  Interpretations

 Time (in years) at which the total value of the


bond is not sensitive to interest rate variation
Time Value of
Money
 If you sell at the time of its duration, holding
period return = current market yield

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


174
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


175
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


176
Time value of money
Risk measurement

 Duration and modified duration

Fundamentals  Implicit assumptions

 All cash flows are discounted at k = YTM

Time Value of  Term structure of interest rate is flat


Money

 Fisher and Weil’s duration

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


177
Time value of money
Risk measurement

 Duration and modified duration


Fundamentals
 Determinants of duration

 Time to maturity
 Coupon
Time Value of
Money  Accrued interest
 Market yield
 Sinking fund
 Call features
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


178
Time value of money
Risk measurement

 Duration and modified duration

Fundamentals  Determinants of duration

 D generally positively related to time to maturity

Time Value of  Maximum value of duration (annual) :


Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


179
Time value of money
Risk measurement

 Duration and modified duration


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


180
Time value of money
Risk measurement

 Duration and modified duration


Fundamentals
 Determinants of duration

 D inversely related to the coupon rate of


interest
Time Value of
Money
 Higher coupon lead to a decline in
duration, but at a diminishing rate

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


181
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


182
Time value of money
Risk measurement

 Duration and modified duration


Fundamentals
 Determinants of duration

 D inversely related to the buildup of accrued


Time Value of interest
Money
 D increases on coupon payment date

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


183
Time value of money
Risk measurement

 Duration and modified duration


Fundamentals
 Determinants of duration

 D inversely related to the general level of


interest rates (yield level)
Time Value of
Money
 Higher discount rate = lower duration

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


184
Time value of money
Risk measurement

 Duration and modified duration

Fundamentals  Using duration to approximate price changes

Time Value of  Modified duration (sensitivity)


Money

 Price duration
Fixed Income
Portfolio
Management
Strategies

 Duration : estimating change in the price for SMALL


change in the yield
Fixed Income : Valuation and Analysis-
185
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


186
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


187
Time value of money
Risk measurement
Initial market yield : 6%; Duration : 7,8 years

 Convexity

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


188
Time value of money
Risk measurement

 Convexity
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


189
Time value of money
Risk measurement

 Convexity

Fundamentals  Duration attempts to estimate convex relationship


with a straight line

 Duration = instantaneous value : Time has an effect


Time Value of
Money
 Will not exhibit the asymmetry in price volatility

 Always underestimate the new price


Fixed Income
Portfolio  Accuracy depends on the convexity
Management
Strategies
 Duration : not for large variation in yield

 Use convexity IN ADDITION to duration


Fixed Income : Valuation and Analysis-
190
Time value of money
Risk measurement

 Convexity
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


191
Time value of money
Risk measurement

 Convexity

Fundamentals  Option-free bond always has a positive convexity

=> Market yield change has always a positive effect


on price
Time Value of
Money

Fixed Income
Portfolio
Management
Strategies
 Convexity = Rate of change of the slope of the
price-yield curve with respect to yield changes

Fixed Income : Valuation and Analysis-


192
Time value of money
Risk measurement

 Convexity
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


193
Time value of money
Risk measurement

 Convexity

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


194
Time value of money

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


195
Time value of money
Risk measurement

 Duration and convexity between coupon payment dates

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


196
Time value of money
Risk measurement

 Impact of coupon payments and time lapse on duration

Fundamentals
 Duration will suddenly increase at the coupon
payment

Time Value of
Money

Fixed Income  Duration will decrease linearly with time between two
Portfolio
Management coupon payments
Strategies
 All other things being equal, duration of a portfolio
will vary linearly over time, except when there is a
coupon payment
Fixed Income : Valuation and Analysis-
197
Time value of money
Risk measurement

 Restrictions on using the duration and convexity

Fundamentals  Duration, bond risk proxy based on three


assumptions :

 A small change in the yield


Time Value of
Money
 A parallel shift in the yield, whatever the maturity

 Instantaneous change in yield


Fixed Income
Portfolio
Management
Strategies
⇒ Assumes a flat yield curve

⇒ Functional duration : price sensitivity to a


particuliar rate change
Fixed Income : Valuation and Analysis-
198
Time value of money
Risk measurement

 Portfolio duration and convexity

Fundamentals  Duration of a bond portfolio is simply the weighted


average of the durations of the individual bonds

Time Value of
Money

 Convexity of a bond portfolio is simply the weighted


Fixed Income average of the convexities of the individual bonds
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


199
Time value of money
Credit risk

 Likelihood that the security’s issuer will default on


Fundamentals payment of interest and/or principal

 Not able to honor the bond indenture

Time Value of  Factor affecting credit risk


Money
 Economic and financial current and prospective
conditions
Fixed Income  Economic / Industry / Firm specific considerations
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


200
Time value of money
Credit risk

 Economic / Industry considerations

Fundamentals  Economic cyclicality

 Growth prospects

Time Value of  Research & development expenses


Money

 Competition

Fixed Income  Sources of supply


Portfolio
Management
Strategies
 Degree of regulation

 Labor

Fixed Income : Valuation and Analysis-


201
Time value of money

Credit risk

 Ratio analysis
Fundamentals
 Cash flow from operations (long term)

 Liquidation of some assets


Time Value of
Money  Another source of financing

=> Analysis of balance sheet & income statement


Fixed Income
accounts
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


202
Time value of money
Credit risk

 Ratio analysis
Fundamentals
 Common size ratios

 Profitability ratios
Time Value of
Money  Liquidity ratios

 Solvency ratios

Fixed Income  Activity ratios


Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


203
Time value of money
Credit risk

 Credit rating and rating agencies


Fundamentals
 EX : Moody’s, Standard & Poor’s

 Analyse various financial data :


Time Value of
Money  Fundamentals of the company

 Industry data

Fixed Income  Macro-economic data


Portfolio
Management
Strategies => Probability of the default in interest and/or
principal payments

Fixed Income : Valuation and Analysis-


204
Time value of money
Credit risk

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


205
Time value of money
Credit risk

 Credit rating and rating agencies

Fundamentals  Independant and unbiaised datas

 Directly reflect the probability of default

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


206
Time value of money
Credit risk

 Credit rating and rating agencies

Fundamentals  Aaa-Baa : Investment quality

 Ba-B : High yield

Time Value of  Caa-C : May have already defaulted and be moving


Money
towards bankrupcy

 High yield : Fallen angels to new issues


Fixed Income
Portfolio  Bond ratings have a direct effect on the borrowing
Management
Strategies costs of the issuer

Fixed Income : Valuation and Analysis-


207
Time value of money
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


208
Time value of money
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


209
Time value of money
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


210
Fixed Income Portfolio Management
Strategies
Active Management : to beat the benchmark

 Forecasting returns
Fundamentals
 Parallel shifts of the yield curve

 More or less steep yield curve


Time Value of
Money  Convexity of the yield curve

 Sector spreads

 Corporate spreads
Fixed Income
Portfolio
Management …
Strategies
 Portfolio Construction

 Information ratio maximisation and optimisation


Fixed Income : Valuation and Analysis-
211
Fixed Income Portfolio Management
Strategies
Active Management in practice

 Constant duration
Fundamentals
 Mean reversion process

 Interest rates above their average value => to


Time Value of decline
Money
 Match duration of the index until upper trigger limit,
then back to average level of the index duration

Fixed Income  Assumption : mean reverting process in interest


Portfolio
Management rates
Strategies
 Risk : Change in medium term inflation rate =>
adjust the model
Fixed Income : Valuation and Analysis-
212
Fixed Income Portfolio Management
Strategies
Active Management in practice

 Return enhancement
Fundamentals
 Use of a valuation model

 Buy the cheap bonds


Time Value of
Money  Arbitrage type

 Options overwriting
Fixed Income
Portfolio  Forecast is on the timing of long term interest
Management rates
Strategies

Fixed Income : Valuation and Analysis-


213
Fixed Income Portfolio Management
Strategies
Active Management in practice

 Return enhancement
Fundamentals
 Minimisation of the value of the bond portfolio

 Liability funding method


Time Value of
Money

 Two constraints :
Fixed Income
Portfolio
Management
Strategies

 IRR of the bond portfolio must equal IRR to discount


present value of the liability
Fixed Income : Valuation and Analysis-
214
Fixed Income Portfolio Management
Strategies
Active Management in practice

 Return enhancement
Fundamentals

 Minimisation of the value of the bond portfolio

 Maximasing IRR of the bond portfolio


Time Value of
Money
 Homogeneous in terms of quality rating

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


215
Fixed Income Portfolio Management
Strategies
Active Management

 Yield spread strategies


Fundamentals
 Type of issuer

 Credit risk
Time Value of
Money
 Coupon level

 Maturity
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


216
Fixed Income Portfolio Management
Strategies
Active Management

 Yield spread strategies


Fundamentals
 Positioning of the portfolio components to gain from
movements in yield spreads

Time Value of  Bond swapping : Sell overvalued bond for


Money
undervalued one

 Credit spread : lower quality trade at a spread


Fixed Income
Portfolio  Tend to widen when recession
Management
Strategies  If economic activity is approaching the peak :
flight to quality

Fixed Income : Valuation and Analysis-


217
Fixed Income Portfolio Management
Strategies
Active Management

 Yield spread strategies


Fundamentals
 Call provision

 Level of interest rates


Time Value of
Money  Volatility

 Decrease in interest rates : swap callable for


non callable
Fixed Income
Portfolio
Management
Strategies  Forecasting term structure of interest rates

 Bond swapping : buy cheapest bonds based


on these assumptions
Fixed Income : Valuation and Analysis-
218
Fixed Income Portfolio Management
Strategies
Active Management

 Yield curve strategies


Fundamentals
 Take advantage of the forecasted movements

 Shift, twist and butterfly of the yield curve


Time Value of
Money
 Yield curve changes : maturity can have a significant
impact on total return of the portfolio

 Bullet strategies / Barbell strategies / Ladder


Fixed Income
Portfolio
strategies
Management
Strategies  Bullet : concentrated on a given point of the yield
curve

 Barbell : extremes of the yield curve


Fixed Income : Valuation and Analysis-
219
Fixed Income Portfolio Management
Strategies

Active Management

Fundamentals  Yield curve strategies

 Laddering

Time Value of  Maturity spacing


Money
 Passive portfolio approach

 Wrong maturity risk minimized


Fixed Income
Portfolio  Reinvestment risk minimized
Management
Strategies

Fixed Income : Valuation and Analysis-


220
Fixed Income Portfolio Management
Strategies
Active Management

 Yield curve strategies


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


221
Fixed Income Portfolio Management
Strategies

Passive Management

 Buy and hold


Fundamentals

 Control risk : duration of the portfolio = duration of the index

 Indexation
Time Value of
Money  Differences with equity indexing :

 Benchmarks are broader

 Turnover is larger : bonds mature, new issues


Fixed Income
Portfolio
Management  Illiquidity
Strategies
 Bond futures : rarely on indices but on notional bonds

Fixed Income : Valuation and Analysis-


222
Fixed Income Portfolio Management
Strategies

Passive Management

 Indexation
Fundamentals

 Differences with equity indexing :

Time Value of  Synthetic replication is impossible


Money

 Bonds more interchangeable and less


specific than equities
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


223
Fixed Income Portfolio Management
Strategies
Passive Management

 Indexing technology
Fundamentals

 Stratified sampling

 Limit the number of bonds


Time Value of
Money
 Avoid trading too small bond positions

 Avoid being in the illiquid segment


Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


224
Fixed Income Portfolio Management
Strategies
Passive Management

 Indexing technology
Fundamentals
 Stratified sampling

 Building index portfolio


Time Value of
Money
 Benchmark partitioned into cells based
on characteristics (sector, maturity,
duration, quality)
Fixed Income
Portfolio  Select a limited number of bonds in
Management each cells
Strategies

 Average characteristics and appropriate


weight
Fixed Income : Valuation and Analysis-
225
Fixed Income Portfolio Management
Strategies
Passive Management

 Indexing technology
Fundamentals
 Optimised sampling

 Overcome the drawbacks of the stratified


Time Value of
Money
sampling approach

 Giving ex-ante measure of the tracking


error
Fixed Income
Portfolio  Optimiser : risk trade-off between
Management
Strategies factors and transaction costs

 Choose the level of tracking error


Fixed Income : Valuation and Analysis-
226
Fixed Income Portfolio Management
Strategies
Passive Management

 Immunisation

Fundamentals  Increase in interest rates :

 Lower value of the bond portfolio

Time Value of  Higher return on the coupon reinvestment


Money
 Balance price risk and reinvestment risk

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


227
Fixed Income Portfolio Management
Strategies
Passive Management

 Immunisation
Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


228
Fixed Income Portfolio Management
Strategies
Passive Management

 Immunisation
Fundamentals
 Short time horizon : effect on the bond price is higher

 Long time horizon : effect of reinvestment of coupons


Time Value of is higher
Money
 Time-horizon for which the final wealth will be the
same, whatever initial interest rate variation
Fixed Income  If time horizon = duration : investor not affected by
Portfolio
Management interest rates variations
Strategies
 Create portfolio with duration = time horizon of the
investor

Fixed Income : Valuation and Analysis-


229
Fixed Income Portfolio Management
Strategies
Passive Management

 Immunisation
Fundamentals
 Portfolio has to be rebalanced whenever a coupon
payment comes due

Time Value of  Portfolio should be rebalanced for each change in


Money interest rates

 Reinvestment of coupon can affect immunization


equilibrium
Fixed Income
Portfolio
Management
=> Immunization has to be dynamic (rebalance
Strategies
frequently)

Fixed Income : Valuation and Analysis-


230
Fixed Income Portfolio Management
Strategies
Passive Management

 Immunisation

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


231
Fixed Income Portfolio Management
Strategies

Passive Management

Fundamentals
 Immunisation

 Tradeoff between frequent rebalancing and


minimizing the transaction costs
Time Value of
Money  Protects against loss but eliminates benefits
from interest rate variation

Fixed Income
 Based on duration : assumes parallel shift of the
Portfolio flat interest rate term structure
Management
Strategies
 Time-passing and yield changing : portfolio
non-immunized

Fixed Income : Valuation and Analysis-


232
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals

 Funding a given set of future liabilities

Time Value of  Build bond portfolio to fund the liability stream


Money
 Compensate the interest rate risk on the liability
side
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


233
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals

 Immunisation

Time Value of
 Fund a liability stream and control for
Money parallel shifts in the yield curve

 L = Present value of the liability stream

Fixed Income
 A = Present value of the cash-flow stream
Portfolio
Management from the bond portfolio
Strategies

Fixed Income : Valuation and Analysis-


234
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals
 Single period immunisation

 Goal : fund the liability and avoid risk of a


Time Value of parallel shift of the interest rate term structure
Money
 Solution : buy zero coupon bonds

 Problem : such ZC bonds may not exist, so use


Fixed Income of ordinary bonds
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


235
Fixed Income Portfolio Management
Strategies

Passive Management

 Liability Funding
Fundamentals

 Single period immunisation

 Both liability and bond portfolio should be discounted at


Time Value of
the same rate (IRR)
Money
 Duration of bond portfolio and liability are equal (single
period : duration = maturity)

Fixed Income  Limited to parallel movements


Portfolio
Management  Convexity
Strategies
 Infinite number of portfolios with duration = T, choose
the bond with cash-flow around the liability maturity =>
less sensitive to non-parallel shifts
Fixed Income : Valuation and Analysis-
236
Fixed Income Portfolio Management
Strategies

Passive Management

 Liability Funding
Fundamentals

 Single period immunisation

 Dispersion of bond portfolio around its


Time Value of
Money duration :

Fixed Income
Portfolio
Management
Strategies  The smaller the dispersion, the smaller the risk

 Immunisation = dynamic strategy


Fixed Income : Valuation and Analysis-
237
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals
 Multiperiod immunisation

 Fund a stream of several liabilities


Time Value of
Money
 Technique for a single liability to each of the
several liabilities

 Identify the duration of the liability stream


Fixed Income
Portfolio
Management 
Strategies
 Risk of discontinuities if large liability matures at
a specific time (dynamic readjustment of the bond
portfolio duration)
Fixed Income : Valuation and Analysis-
238
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals

 Surplus immunisation

Time Value of  Investor owns assets in excess of the present


Money value of his liabilities

S=A–L
Fixed Income
Portfolio  To immunise :
Management
Strategies  Positive surplus : Duration of A should be
smaller

Fixed Income : Valuation and Analysis-


239
Fixed Income Portfolio Management
Strategies

Passive Management

Fundamentals  Liability Funding

 Cash flow matching


Time Value of
Money  Create a bond portfolio whose stream of
cash flows exactly matches stream of
liabilities

Fixed Income  Create a ZC for each liability and maturity


Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


240
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals
 Cash flow matching

 With normal bonds : iterative process


Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


241
Fixed Income Portfolio Management
Strategies

Passive Management

 Liability Funding
Fundamentals

 Cash flow matching

 Linear programming techniques : least-cost cash


Time Value of
Money flow matching

 Drawbacks :

Fixed Income
 Difficulties of perfect date matching
Portfolio
Management  Difficult exact amount matching (rounding in
Strategies the bond quantities)

Fixed Income : Valuation and Analysis-


242
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals
 Asymmetric cash matching

 Cash flows on the bond portfolio matures only


BEFORE
Time Value of
Money
 Build a non-callable bond portfolio of
homogeneous characteristics

 Cumulative bond cash flow larger than cumulative


Fixed Income
Portfolio cash flow of the liabilities (any liabilities is funded)
Management
Strategies  Amount and maturity of cash flows should match
as far as possible (limit term structure risk factor)

Fixed Income : Valuation and Analysis-


243
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals
 Asymmetric cash matching

 Technique : minimising the value of the portfolio : the


Time Value of cheapest portfolio is also the best cash flow match
Money
 Only with bonds of the same quality

 Cash in advance to fund liabilities


Fixed Income
Portfolio  Reinvestment based on an assumption for cash rate
Management
Strategies ⇒ Reinvestment risk if cash is actually smaller

⇒ Take advantage of the evolution of the term structure


to build an even cheaper bond portfolio
Fixed Income : Valuation and Analysis-
244
Fixed Income Portfolio Management
Strategies
Passive Management

 Liability Funding
Fundamentals

 Symmetric cash matching

 If you can borrow cash for a short period,


Time Value of
Money bond cash flow can occur AFTER

 Bond portfolio with cash flows AROUND the


maturity of liabilities
Fixed Income
Portfolio
Management  Can be cheaper depending on the borrowing
Strategies costs

Fixed Income : Valuation and Analysis-


245
Fixed Income Portfolio Management
Strategies
Portfolio construction based on a factor model

 Volatility of the term structure => MFM for better risk control
Fundamentals
 Model specification

 Single factor duration model


Time Value of
Money

Fixed Income  For instantaneous change in yield


Portfolio
Management  Ignore the interest accrual
Strategies
 Assume that duration is constant through time

Fixed Income : Valuation and Analysis-


246
Fixed Income Portfolio Management
Strategies

Portfolio construction based on a factor model

Fundamentals
 Single factor duration model

 Relates volatility of a bond return to the volatility of its


current yield
Time Value of  Duration = factor exposure of the bond
Money
 Assumptions :

 Term structure is flat


Fixed Income
Portfolio  Only small parallel shifts
Management
Strategies  Explains 75% of the variance of non-callable US Treasury
bond return

 Quality of the forecast can be improved with convexity


Fixed Income : Valuation and Analysis-
247
Fixed Income Portfolio Management
Strategies
Portfolio construction based on a factor model

 Full term structure MFM


Fundamentals

 Return of a bond is a weighted average of the return of


Time Value of
Money the discount bonds

Fixed Income
Portfolio  Z = exposure of a bond to all discount bonds
Management  W = covariance matrix for the return of the set of discount
Strategies bonds

⇒ Fully predictive risk model


⇒ Not convenient for complicated movements in the curve
Fixed Income : Valuation and Analysis-
248
Fixed Income Portfolio Management
Strategies
Portfolio construction based on a factor model

 The shift, twist and butterfly MFM

 Smaller number of factors => easier to model movements of the


Fundamentals
term structure

 Risk : loosing risk explanation

Time Value of  Factors :


Money
 Return of the shift factor
 Return of the twist factor
 Return of the butterfly factor

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


249
Fixed Income Portfolio Management
Strategies
Portfolio construction based on a factor model

 The shift, twist and butterfly MFM

Fundamentals  If RS > 0 : parallel shift in the term structure (positive


return on discount bonds => discount yields declined)

 If RT > 0 : positive return on short term maturities,


Time Value of negative on long term (steeper curve, positive twist)
Money
 If RB > 0 : Positive return on both end of maturities.
Negative on intermediate (more concave curve)

Fixed Income
Portfolio
Management
Strategies

 W = 3 x 3 covariance matrix of the shift, twist and


butterfly returns
Fixed Income : Valuation and Analysis-
250
Fixed Income Portfolio Management
Strategies
Portfolio construction based on a factor model

 Summary and needed enhancements


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management  There are other risks than movements in the term structure
Strategies
 Existence of options, sinking fund provisions
 Default risk
 Tax
Fixed Income : Valuation and Analysis-
251
Fixed Income Portfolio Management
Strategies
Portfolio construction based on a factor model

 Summary and needed enhancements


Fundamentals

 Specific part in the explanation of the return of


a bond is relatively small
Time Value of
Money  Bonds are more interchangeable

 Less emphasis on diversification


Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


252
Fixed Income Portfolio Management
Strategies
Portfolio construction based on a factor model

Fundamentals
 Interest rate anticipation strategies

 Active bond management : scenario for the


forecast of the movements of the yield curve
Time Value of
Money
 Build a portfolio with risk exposure consistant
with his prediction of the term structure
movements
Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


253
Fixed Income Portfolio Management
Strategies

Portfolio construction based on a factor model

Fundamentals  Interest rate anticipation strategies

 Forecast downward parallel shift of the term structure


=> More exposed to the shift factor than the
Time Value of benchmark
Money
 Forecast steeper term structure :
=> Exposure to the twist factor higher than the
benchmark
Fixed Income
Portfolio
 Forecast more concave term structure :
Management
Strategies => Exposure to the butterfly factor higher than
the benchmark

 Overweight sector, rating, …


Fixed Income : Valuation and Analysis-
254
Fixed Income Portfolio Management
Strategies

Portfolio construction based on a factor model

Fundamentals  Interest rate anticipation strategies

 Build bond portfolio

Time Value of  Duration, convexity consistent with his


Money
scenario

 Risk model
Fixed Income
Portfolio  Optimiser to minimise tracking error with
Management constrains on risk exposures
Strategies

 Forecast factor returns => maximise forecasted


risk adjusted active return of the bond portfolio
Fixed Income : Valuation and Analysis-
255
Fixed Income Portfolio Management
Strategies
Computing the hedge ratio : the modified duration method

 Hedge bond portfolio with future contracts


Fundamentals
 Optimal hedge ratio :

Time Value of
Money

 Assumes only parallel shifts in the yield curve

Fixed Income  Risk if big differences between MDS and MDF


Portfolio
Management
Strategies  Omits convexity (convexity between CTD and asset being
hedged)

 Optimal number of contracts change with CTD


Fixed Income : Valuation and Analysis-
256
Fixed Income Portfolio Management
Strategies
Computing the hedge ratio : the modified duration method

 Number of future contracts :


Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies
 Short hedge : Sell interest rate futures to « freeze » low
interest rates today
Fixed Income : Valuation and Analysis-
257
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


258
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


259
Fixed Income Portfolio Management
Strategies
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


260
Fixed Income Portfolio Management
Strategies
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


261
Fixed Income Portfolio Management
Strategies

EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


262
Fixed Income Portfolio Management
Strategies
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


263
Fixed Income Portfolio Management
Strategies
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


264
Fixed Income Portfolio Management
Strategies
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


265
Fixed Income Portfolio Management
Strategies

EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


266
Fixed Income Portfolio Management
Strategies
EVALUATION AND RISK

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


267
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


268
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


269
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


270
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

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271
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

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272
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


273
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


274
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

Fixed Income : Valuation and Analysis-


275
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

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276
Fixed Income Portfolio Management
Strategies

Fundamentals

Time Value of
Money

Fixed Income
Portfolio
Management
Strategies

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