Topic 4 - BMGT 343: Investments Prof. Anna A. Obizhaeva...

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1 Fixed Income Anna A.Obizhaeva BMGT 343: Investments Prof. Anna A. Obizhaeva Office: VMH 4428 Phone: (301) 405-7934 Email: obizhaeva@rhsmith.umd.edu Section 0101 T Th 9:30-10:45 am in VMH 1336 Section 0201 T Th 11:00-12:15 pm in VMH 1336 Section 0301 T Th 12:30-1:45 pm in VMH 1336 Office Hours : Thu 3:00-4:00 pm or by appointment Fixed Income Anna A.Obizhaeva Fixed Income Topic 4: Managing Bond Portfolios
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2 Fixed Income Anna A.Obizhaeva Recap of What We Learned So Far In the previous class, we have discussed that interest rates are usually not constant and fluctuate a lot over time. This dynamics is the source of risk for bond positions. The next question is how market participants can avoid taking this risk into their portfolios. In particular, we will focus on the hedging of bond portfolios against the parallel shifts in the yield curve. Fixed Income Anna A.Obizhaeva Outline for Topic 4 The sensitivity of bond prices to the changes in interest rates can be approximated by the duration of bonds . This measure might help to construct the immunized bond portfolios, insensitive to the changes in interest rates.
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3 Fixed Income Anna A.Obizhaeva Why Hedge? Some Recent Big Losses trader amount instrument year institution Nicholas Leeson Robert Citron Joe Jett Jerome Kerviel $1.4 billion $2.0 billion $ 1.0 billion $7.0 billion Nikkei index options Bond derivatives Mortgage-backed securities Futures on European Indices 1995 1994 1994 2008 Baring Orange County Kidder-Peabody Societe Generale Fixed Income Anna A.Obizhaeva Three Factors That Can Describe Yield Curve Three factors capture the rich dynamics of yield curve: level , slope , and curvature factors. The most important factor is the level of yield curve.
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4 Fixed Income Anna A.Obizhaeva Three Factors That Can Describe Yield Curve (cont’d) Since the most important factor is the level of yield curve, we will assume that the yield curve is flat at level r across all maturities, but its level might change over time. How can we deal with this risk of changing r or parallel shifts in yield curve? Fixed Income Anna A.Obizhaeva 1. Performance Profile Let’s see how the bond investment changes if interest rates change . We will be looking at performance profile . Consider an investment in the bond, worth $1 at the current interest rate . What is the value of the investment when interest rate moves from to ? r r Δ + r r
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5 Fixed Income Anna A.Obizhaeva Defining Performance Profile • Price of the bond with coupon rate c% and T years to maturity at : • Price of the bond at : • Units of the bond that can be bought with $1 at : Value of the investment at : T r c r c r c r P ) 1 ( 100 ... ) 1 ( 1 ) ( 2 + + + + + + + = ) ( / 1 r P ) ( ) ( 1 r r P r P Δ + × r r Δ + r r r r Δ + T r r c r r c r r c r r P ) 1 ( 100 ... ) 1
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This note was uploaded on 12/02/2011 for the course BMGT 343 taught by Professor Staff during the Fall '08 term at Maryland.

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Topic 4 - BMGT 343: Investments Prof. Anna A. Obizhaeva...

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