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Fixed-Income Portfolio Management

This document discusses strategies for fixed-income portfolio management including risk management, trading based on interest rate predictions, and exploiting market inefficiencies. It then provides details on duration including the formula for calculating duration, how duration is affected by factors like maturity and coupon rate, and how duration relates to the price sensitivity of a bond to changes in interest rates. It also discusses strategies for passive risk management like bond index funds, immunization, and cash flow matching to manage interest rate risk.

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annie:X
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Download as PPT, PDF, TXT or read online on Scribd
39 views

Fixed-Income Portfolio Management

This document discusses strategies for fixed-income portfolio management including risk management, trading based on interest rate predictions, and exploiting market inefficiencies. It then provides details on duration including the formula for calculating duration, how duration is affected by factors like maturity and coupon rate, and how duration relates to the price sensitivity of a bond to changes in interest rates. It also discusses strategies for passive risk management like bond index funds, immunization, and cash flow matching to manage interest rate risk.

Uploaded by

annie:X
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Fixed-Income Portfolio Management

Strategies

Risk Management

Trade on interest rate predictions

Trade on market inefficiencies


Duration
A measure of the effective maturity of a bond
The weighted average of the times until each
payment is received, with the weights proportional
to the present value of the payment

Duration = the 1st-order derivative of bond price


with respect to yield.
Duration = bonds sensitivity to interest-rate risk
Duration Formula
T
D t wt

t 1

t
wt CF t (1 y ) Price

CFt Cash Flow for period t


Properties of Duration
The longer a bonds maturity, the longer its
duration and hence the more risky.

Duration is shorter than maturity for all bonds


(except zero coupon bonds)

Duration = maturity, for zero -coupon bonds


Duration: Example
8% Time Payment PV of CF Weight
Bond years (10%) t*wt
.5 40 38.095 .0395 .0198

1 40 36.281 .0376 .0376

1.5 40 34.553 .0358 .0537

2.0 1040 855.611 .8871 1.7742

sum 964.540 1.000 1.8853


Duration/Price Relationship
Price change is proportional to duration and not to
maturity

P/P = -D {(1+y) / (1+y) }


or,
P/P = - D* y

where D* = D / (1+y), modified duration


Rules for Duration
Rule 1 The duration of a zero-coupon bond equals its time to
maturity
Rule 2 Holding maturity constant, a bonds duration is higher
when the coupon rate is lower
Rule 3 Holding the coupon rate constant, a bonds duration
generally increases with its time to maturity

Rule 4 Holding other factors constant, the duration of a coupon


bond is higher when the bonds yield to maturity is lower
Passive (Risk) Management
Bond-Index Funds

Immunization of interest rate risk


Net worth immunization
Duration of assets = Duration of liabilities
Target date immunization
Holding Period matches Duration

Cash flow matching and dedication


Duration and Convexity
Price

Pricing Error
from convexity

Duration

Yield
Adjusting for Convexity

1 n
CFt
Convexity
P (1 y ) 2

t 1
(1 y ) t (t t )
2


Thus, adjusting for Convexity, we have

P
D y 1 [Conveixity (y ) 2 ]
P 2
Better Risk Management
For the previous types of funds/portfolios

Duration Matching

duration of assets = duration of liabilities

Convexity Matching:

convexity of assets = convexity of liabilities

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