What is time value of money and how it is impacted?
The return the average lender requires to postpone consumption today in exchange for consumption tomorrow and it impacted by:
1. Inflation expectations
2. Impatience/opportunity costs
3. Market interest rate
How is interest rate risk of a bond increased?
- Longer maturity
- Lower coupon rate
- Low initial yield
What is the duration of a bond?
This captures how long, on average, our capital is tied up
What are the three reasons that duration is a key concept in fixed-income portfolio management?
- Simple summary statistic of the effective average maturity of the portfolio
- Essential tool in immunizing portfolios from interest rate risk
- Measure of the interest rate sensitivity of a portfolio
What determines duration?
- The duration of a zero-coupon bond equals its time to maturity
- Holding maturity constant, a bonds duration is lower when the coupon rate is higher
- Holding the coupon rate constant, a bonds duration generally increases with its time to maturity
- Holding other factors constant, the duration of a coupon bond is higher when the bonds yield to maturity is lower
- Formula for the duration of a perpetuity = (1+ y) / y
Why do investors like convexity?
Bonds with greater curvature (more convex) gain more in price when yields fall than they lose when yields rise
What is price compression?
There is a ceiling on the possible price
What are the two types of passive bond management>
- Indexing strategy: Attempts to replicate the performance of a given bond index
- Immunization techniques: Designed to shield from interest rate fluctuations
What are challenges in constructing a indexed bond portfolio?
- Bond indexes include thousands of securites and difficult to purchase each security in the index in proportion to its market value
- The compositions of the index changes daily
What are solutions to the challenges in constructing a indexed bond portfolio?
- Cellular approach
- Purchase a bond Exchange-Traded fund
What are other types of immunization?
- Cash flow Matching
- Dedication strategy: Cash flow-matching on a multi-period basis, its a once and-for all approach
What are two types of active bond management?
- Correctly forecasting interest rate changes
- Finding fixed-income securities with mispriced credit risk
