L Pch14

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L Pch14

  1. 1. Investments Chapter 14: Bonds: Analysis and Management
  2. 2. Pricing Bonds <ul><li>The price of a bond is the present value of all future coupon payments plus the par value discounted at the yield to maturity: </li></ul>
  3. 3. Bond Pricing Principles: I Exhibit 14.1 Bond prices and the passage of time for different yields to maturity (spikes due to the coupon accrual) Source: From Introduction to Investments , 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.
  4. 4. Bond Pricing Principles: II <ul><li>Bond Prices are Related Inversely to the Yield to Maturity: </li></ul>Exhibit 14.2 Convex relationship between bond prices and yield to maturity Source: From Introduction to Investments , 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.
  5. 5. Bond Pricing Principles: III <ul><li>The Longer the Maturity, the More Sensitive a Bond’s Prices are to Changes in the Yield to Maturity: </li></ul>Exhibit 14.4 Bond prices and yield to maturity for different lengths to maturity Source: From Introduction to Investments , 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.
  6. 6. Bond Pricing Principles: IV <ul><li>The Sensitivity of the Price of a Bond to Changes in the Yield to Maturity Increases at a Decreasing Rate with the Length to Maturity: </li></ul>Exhibit 14.5 Difference between bond prices for different yields to maturity for bonds of different maturities Source: From Introduction to Investments , 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.
  7. 7. Bond Pricing Principles: V <ul><li>There is a Linear Relationship between a Bond’s Coupon Rate and its Price: </li></ul>Exhibit 14.6 Linear relationship between bond price and coupon rate for different yields to maturity
  8. 8. Duration <ul><li>Two competing interest-rate effects on the value of bond portfolios: </li></ul><ul><li>1. The price effect. </li></ul><ul><li>2. The reinvestment effect. </li></ul><ul><li>The holding period for which the two effects cancel each other out is known as the duration of the bond portfolio. </li></ul>
  9. 9. The Trade-off between the Price Effect and the Reinvestment Effect Exhibit 14.10 Duration as a measure of the holding period that minimises interest-rate risk measured as the standard deviation of rates of return (holding period is assumed to be four years)
  10. 10. Formal Definition of Duration <ul><li>Duration is ‘a present value-weighted average of the number of years investors weight to receive cash flows’: </li></ul>
  11. 11. Duration Principles <ul><li>Duration is related inversely to yield to maturity. </li></ul><ul><li>Duration depends positively on the length to maturity. </li></ul><ul><li>Duration is related inversely to the level of coupon payments. </li></ul><ul><li>Duration of a bond portfolio is equal to a weighted average of the durations of the individual bonds. </li></ul>
  12. 12. Convexity <ul><li>Duration is a measure of the slope of a bond’s price – yield relationship. </li></ul><ul><li>Convexity is a measure of the curvature of this price – yield relationship. </li></ul>
  13. 13. Convexity Principles <ul><li>1. Convexity is related inversely to yield to maturity. </li></ul><ul><li>2. Convexity is related positively to length to maturity. </li></ul><ul><li>3. Convexity is related inversely to the coupon. </li></ul><ul><li>4. The convexity of a bond portfolio is equal to a weighted average of the convexity of the individual bonds. </li></ul>
  14. 14. Passive vs. Active Bond Management <ul><li>Passive Bond Management </li></ul><ul><li>Manager does not attempt to identify bonds that are under- or overpriced. </li></ul><ul><li>Active Bond Management </li></ul><ul><li>Manager does attempt to identify bonds that are under- or overpriced. </li></ul>
  15. 15. Passive Bond Management Strategies <ul><li>Indexing strategies. </li></ul><ul><li>Immunisation strategies/duration-matching strategies. </li></ul>
  16. 16. Active Bond Management Strategies <ul><li>There are many different bond-management strategies, for example: </li></ul><ul><li> A substitution swap. </li></ul><ul><li> A pure yield pick-up swap. </li></ul><ul><li> A rate anticipation swap. </li></ul>

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