Robert j mckeown u of t eco358 week nine passive bond

This preview shows page 51 - 62 out of 72 pages.

Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 51

Subscribe to view the full document.

Passive Bond Management & Immunization What if rates fall in one year? Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 52
Passive Bond Management & Immunization What if rates rise in one year? Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 53

Subscribe to view the full document.

Passive Bond Management & Immunization How does duration matching work? Suppose interest rates increase at time t . The price of the bond portfolio falls, but the proceeds are reinvested at a higher yield. The result? Success! The desired funds are available at time T . Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 54
Passive Bond Management & Immunization How does duration matching work? Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 55

Subscribe to view the full document.

Passive Bond Management & Immunization How does duration matching work? How does duration matching work? It keeps the present value of the assets equal to the present value of liabilities. In our previouse example, we had a liability worth $ 14, 693.28 / 1.08 5 = $ 10, 000 and a bond selling at par-value, $10,000. Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 56
Passive Bond Management & Immunization Present value and duration matching Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 57

Subscribe to view the full document.

Passive Bond Management & Immunization Limitations of duration matching As interest rates changes become larger, duration matching is less perfect. Why? First, the individual bonds (or coupon-payments) in a portfolio have a duration that varies with interest rates. This is caused by convexity . Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 58
Passive Bond Management & Immunization Limitations of duration matching Recall that a bond with greater convexity will have a higher price movement if rates fall, and a lower price movement if rates rise. This will cause the duration of the underlying bonds (coupons) to vary. Since the underlying bonds (coupons) have di erent durations, the duration of the portfolio also changes. Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 59

Subscribe to view the full document.

Passive Bond Management & Immunization Present value and duration matching Second, as coupon bonds approach maturity, duration will decrease less quickly than maturity itself. This causes the duration of our bond portfolio to change, but more importantly, it will change at a di erent rate than the liability it matches. Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 60
Passive Bond Management & Immunization Limitations of duration matching The impact of convexity and maturity on duration highlights the importance of rebalancing immunization portfolios. Over time, the portfolio manager must buy and sell bonds to ensure the duration of assets equals the duration of liabilities. The only thing “passive” about immunization is that it does not seek mispriced assets – but there can be a lot of trading involved! Robert J. McKeown (U of T) ECO358 Week Nine
Image of page 61

Subscribe to view the full document.

Passive Bond Management & Immunization Banks and Gap Management Banks hold bonds with interest rate risk.
Image of page 62
You've reached the end of this preview.
  • Summer '14
  • ATAMAZAHERI
  • Robert J. McKeown

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern