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Fixed Income Review (L1-2)

Duration = - (% ∆, bond price) / (% ∆, yield)... think of duration as slope of yield curve

==> Approx. % ∆ in price = - duration * (% ∆, yield), small chgs only

** Measures slope of price/yield curve (yield on x-axis, price on y-axis)

Effective Duration (ED) = (value, yield falls by ∆ in y - value, yield rises by ∆ in y) / (2 * initial
value * ∆y)

** approximates % ∆ in price for 100 bps ∆ in YTM

Modified Duration (MD): assumes CF's on bond won't ∆ (unlike ED, which considers features
like embedded options)

Dollar Duration = E(D) * Bond Price * 0.01

(or, approx. chg. in $ for 100 bps ∆ in yield)

Portfolio DD = sum (i=1, n) [DDi)

Rebalancing Ratio = old DD / new DD, or required add'l cash to readjust P to original DD

Dollar Value of Basis Point (DVBP): ∆ in sec value for 1 bps ∆ in r (= duration * 1,000 * value)

Key Rate Duration: approx. % ∆ in bond value for 100 bps ∆ in a key rate, holding all other rates
constant. Useful to measure convexity, i.e. effect of non-parallel curve shift.

Yield Curve: graphical representation, term structure of int rates.. yield curve risk = non-parallel
shift in curve

Positive Convexity: duration higher at low rates, lower at high rates

Negative Convexity: e.g. callable. Duration lower at low rates (i.e. call price is the ceiling)

Characteristic Int Rate Risk Duration

Maturity Up Up Up
Coupon Up Down Down
Add a Call Down Down
Add a Put Down Down

Bond Valuation: est. CF's over life, then compute PV using appropriate discount rate

Current yield ==> annual coupon/bond price

YTM ==> rate where PV (bond's promised CF's) = market price

BEY ==> 2* YTM(semi-annual pay) or 2* [(1 + YTM(annual pay)^1/2) -1]

Zero coupon ==> [(face value/price)^(1/2*N) - 1] * 2

** YTM assumes bond HTM & all interim CF's reinvested at YTM

Yield Spreads:

Absolute = bond yield - benchmark (usually Treasuries)

Relative = (Bond Yield/Benchmark) - 1

Nominal = issue's YTM - Treasury YTM of similar maturity

Z-Spread = spread added to all SR's on yield curve s.t. PV of CF's equals the mkt price (note that
same spread added to all).

**equals the nominal spread IFF flat term structure

OAS = Z-spread - cost, embedded option (in %)

**removes yield differences due to embedded option

Credit Spread: yield diff. b/w 2 issues that are identical except credit rating

Bootstrapping (implied spot rates): find rate s.t. mkt value of a certain coupon bond equals
discounted PV of the associated CF's.

(Usually are given one or more spot rates; use to discount CF's occurring on those dates. With
coupon bond price on left-hand side of equation, solve for missing SR.)

Forward rate: borrow/lending rate at some future pt. Investor indifferent b/w holding coupon
bond to maturity & receiving associated CF's and reinvesting at the forward rates.

e.g. 1-period forward rate, n periods from today= (1+ SR(n+1))^(n+1) / (1 + SR(n))^n - 1

Treasury Bond Futures: U/L instrument is $100K par value of 30-yr, 6% coupon. Seller can deliver
among several
acceptable instruments: at least 15 yrs to maturity from delivery date, must not be callable w/n
this period
(CBOT rules).

Conversion factors==> determine invoice p of each acceptable delivered Treasury. Based on p

that bond would sell
for at beginning of delivery month, if were to yield 6%. Short selects cheapest-to-deliver (CTD) &
has 2 other
options: (1) timing (when w/n month actual delivery occurs) (2) wild card (right to give notice of
delivery intent
up to 8:00 p.m. CST on date futures settlement p is fixed).

Interest Rate Futures: prices negatively correlated w/int rates (r increases ==> deliverable bond
p decreases ==>
futures p decreases). Therefore, P duration increases.

Interest Rate Risk, Measurement:

(1) Full Valuation/Scenario Analysis (preferred)

* start w/current mkt yield, price

* est. ∆ in yield

* revalue bonds, given above

* compare new & old values

(2) Duration/Convexity Approach (simpler). See "Duration" notes above for formulas.

*Semi-Annual Total Return, Bond = (Total Future $$ / Full Bond Pr)^1/n -1

where n: # of periods in inv't horizon

Yield Curve Risk - major source; includes parallel shift (= 90% of bond value chg), twists and
other curvature chgs. Dimension via key rate duration.

Interest Rate Risk - sensitivity to chgs. in int rate level

Spread Risk - sensitivity to chgs. in spreads b/w gov't and non-