Lecture 4-5.ppt - Lecture 4 Bond Portfolio Management...

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Lecture 4 - Lecture 4 - Bond Portfolio Management Bond Portfolio Management
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2 Topics Passive bond portfolio management. What is portfolio immunization. Facts about interest rate risk. Duration. Using duration for the purpose of immunization. Active bond portfolio management.
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3 Bond portfolio management Bond portfolio management There are two types of bond portfolio management: Passive: following bond indexes such as Citigroup World Government Bond Index Value weighted index of fixed-rate gov bonds with maturity > 1 year Immunization To protect the net worth of financial institutions such as banks against shocks due to interest rate fluctuations. To ensure the ability of institutions such as pension funds to fulfil their obligations. Active: interest rate forecasting, search for mispriced bonds.
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4 Immunization Immunization Constitutes a protection of the net worth from interest rate fluctuations. MV(equity) = MV(assets) - MV(debt) Are the liabilities of banks long term or short term liabilities? What about the banks’ assets? How would a rise in the interest rates (for various maturities) affect the market value of the banks’ stocks?
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5 Immunization Immunization Example: 2003 was a good year for both stocks and bonds. The S&P 500 increased by 25%. The value of assets of the US pension funds increased by more than 100 billion dollars! But the PV of their obligations grew by much more, so that they entered an actuary deficit. The reason was a sharp decline in the interest rate (Greenspan ear). Why? The average obligation of the funds was for 15 years, whereas the average life of the assets (mainly bonds but also stocks) was 5 years. (why did they invest in stocks?).
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6 Immunization Immunization We can think of it as follows: After the decline in the interest rate, in order to be able to fulfil their obligations they had to invest more money relative to before the interest rate decline. In general a low interest rate environment is problematic for pension funds since it’s more difficult to finance future obligations.
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Facts about interest rate risk Facts about interest rate risk (price risk) (price risk) Recall that the price of a bond depends on the various interest rates. The bond’s YTM is a weighted average of the various interest rates for different maturities . 7
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8 Facts about interest rate risk Facts about interest rate risk (price risk) (price risk) There is a negative relation between bond prices and the interest rates. Importantly, when we hear that bond yields increased the meaning is that their prices fell. The relation between a bond’s price to its YTM (which is an average of the interest rates) is convex.
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Facts about interest rate risk Facts about interest rate risk (price risk) (price risk) The prices of long term bonds are more sensitive to changes in the interest rates than the prices of short term bonds.
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