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22

  1. 1. CHAPTER TWENTY-TWO BOND PORTFOLIO MANAGEMENT 1
  2. 2. BOND PORTOLIOS • METHODS OF MANAGEMENT – Passive • rests on the belief that bond markets are semi-strong efficient • current bond prices viewed as accurately reflecting all publicly available information 2
  3. 3. BOND PORTOLIOS • METHODS OF MANAGEMENT – Active • rests on the belief that the market is not so efficient • some investors have the opportunity to earn above- average returns 3
  4. 4. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – for a typical bond making periodic coupon payments and a terminal principal payment 4
  5. 5. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 1 • If a bond’s market price increases • then its yield must decrease • conversely if a bond’s market price decreases • then its yield must increase 5
  6. 6. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 2 • If a bond’s yield doesn’t change over its life, • then the size of the discount or premium will decrease as its life shortens 6
  7. 7. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 3 • If a bond’s yield does not change over its life • then the size of its discount or premium will decrease • at an increasing rate as its life shortens 7
  8. 8. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 4 • A decrease in a bond’s yield will raise the bond’s price by an amount that is greater in size than the corresponding fall in the bond’s price that would occur if there were an equal-sized increase in the bond’s yield • the price-yield relationship is convex 8
  9. 9. BOND PRICING THEOREMS • 5 BOND PRICING THEOREMS – THEOREM 5 • the percentage change in a bond’s price owing to a change in its yield will be smaller if the coupon rate is higher 9
  10. 10. CONVEXITY CONVEXITY DEFINITION: – a measure of the curvedness of the price-yield relationship 10
  11. 11. CONVEXITY • THE PRICE-YIELD RELATIONSHIP Price YTM 11
  12. 12. CONVEXITY • THEOREM 1 TELLS US – price and yield are inversely related but not in a linear fashion (see graph) – an increase in yield is associated with a drop in bond price – but the size of the change in price when yield rises is greater than the size of the price change when yield falls 12
  13. 13. DURATION • DEFINITION: – measures the “average maturity” of a stream of bond payments – it is the weighted average time to full recovery of the principal and interest payments 13
  14. 14. DURATION • FORMULA T  P V (Ct )  D   t where P0 = the 1  market price of t current P 0  the bond PV(Ct )= the present value of the coupon payments t = time periods 14
  15. 15. DURATION • THE RELATION OF DURATION TO PRICE CHANGES – THEOREM 5 implies • bonds with same maturity date but different coupon rates may react differently to changes in the interest rate • duration is a price-risk indicator 15
  16. 16. DURATION • DURATION IS A PRICE-RISK INDICATOR – FORMULA p rewritten   D (1  ytm ) p where y = thep  yield  maturity bond’s  D  y  to  1 y  p   16
  17. 17. DURATION • MODIFIED DURATION – FORMULA: D Dm  1 y – reflects the bond’s % price change for a one percent change in the yield 17
  18. 18. DURATION • THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION – whereas duration would have us believe that the relationship between yield and price change is linear – convexity shows us otherwise 18
  19. 19. DURATION • THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION P C 0 YTM 19
  20. 20. IMMUNIZATION • DEFINITION: a bond portfolio management technique which allows the manager to be relatively certain of a given promised cash stream 20
  21. 21. IMMUNIZATION • HOW TO ACCOMPLISH IMMUNIZATION – Duration of a portfolio of bonds • equals the weighted average of the individual bond durations in the portfolio – Immunization • calculate the duration of the promised outflows • invest in a portfolio of bonds with identical durations 21
  22. 22. IMMUNIZATION • PROBLEMS WITH IMMUNIZATION – default and call risk ignored – multiple nonparallel shifts in a nonhorizontal yield curve – costly rebalancing ignored – choosing from a wide range of candidate bond portfolios is not very easy 22
  23. 23. ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT – Horizon Analysis • simple holding period selected for analysis • possible yield structures at the end of period are considered • sensitivities to changes in key assumptions are estimated 23
  24. 24. ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT – Bond Swapping • exchanging bonds to take advantage of superior ability to predict yields • Categories: – substitution swap – intermarket spread swap – rate anticipation swap – pure yield pickup swap 24
  25. 25. ACTIVE MANAGEMENT • TYPES OF ACTIVE MANAGEMENT – Contingent Immunization • portfolio managed actively as long as favorable results are obtained • if unfavorable, then immunize the portfolio 25
  26. 26. PASSIVE MANAGEMENT • TYPES OF PASSIVE MANAGEMENT – INDEXATION • the portfolio is formed to track a chosen index 26

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