This Is especially crucial for bonds with maturity dates 20 years or more into the future. Without scalability, a company might issue bonds with a high interest rate and not be able to change the rate for 20 years. The company could find itself locked into a high rate for many years at a time when new bonds are being issued with much lower interest rates. The company would be at a competitive disadvantage If It continued to finance its debts at the old, higher rate. Companies are often willing to pay a premium to redeem the bonds before maturity, to avoid the above scenario.
Scalability enables the company to respond to hanging interest rates, refinance high-interest debts, and avoid paying more than the going rates for its long-term debts. 2. Briefly explain the idea behind an Minimized Bond Portfolio. With an Minimized Portfolio, the duration and convexity of the assets Is set to match the duration and convexity of the liabilities. The IV of the assets Is set greater than the IV of the liabilities. For small changes In yield, the asset value should Increase or decrease proportionally to the changes in the value of the liabilities.
This method insures that the return on the assets and the return on the liabilities remain the same. Another way of looking at it is that immunization sets the price risk exactly equal to the reinvestment risk. 2. Briefly explain the Idea behind an Minimized Bond Portfolio. With an Minimized Portfolio, the duration and convexity of the assets is set to match the duration and convexity of the liabilities. The IV of the assets is set greater than the IV of the liabilities.
For small changes in yield, the asset value should increase or decrease proportionally to the changes in the value of the liabilities. This method insures that the return on the assets and the return on the liableness remain the same. Another way of looking at It Is that Immunization sets the price risk exactly equal to the reinvestment risk. 3. Explain why an Interest Only Strip (10 MBPS) usually gains value when interest rates increase. 10 Strips receive the Interest portion of a MBPS. If Interest rates decrease, then in the future.
While these smaller payments are discounted at a lower rate, the net effect is usually a decrease in value. 4. Briefly explain what happens to the price of a straight bond (no options) when the yield increases – and why. Price goes down when yields go up. I needed you to tell me why. I accepted any of the here reasons from the Bond Analytics lecture notes. 5. Briefly describe how the Federal Reserve moves rates in the Federal Funds Market. 6. Suppose that you want to hedge the interest rate risk of a Fixed Income Security that has negative convexity.
Suppose that you can create a perfect hedge with futures and options (paying a premium to buy the options). As an alternative, you can use hedge with futures alone. If you believe that the true volatility will be much lower than the implied volatility of the options, which alternative should you choose? Why? 7. Briefly explain the idea behind splitting a companion COM trance into a floating ate class and an inverse rate floating rate class. 8. Suppose that a fixed cash flow treasury bond is split into two bonds, a floater and an inverse floater.
Briefly explain why the Inverse Floating Rate Bond has a much longer effective duration than the underlying fixed cash flow. 9. Briefly explain why Salomon Brothers was able to make a profit while they were squeezing the Two-Year Treasury. 10. Briefly explain why straight Corporate Bonds have a higher yield than Treasury Bonds with the same coupon rate and maturity. 11. Theoretical Spot Rates will be close to Zero Coupon Bond Yields. Explain why there may be small differences in the real world. 12.
Assume the following (all rates are stated annually with semiannual compounding): a. Six Month Spot Rate is 2. 5% b. Six Month Forward rate starting at month six is 2. 8% c. Six Month Forward rate starting at month 12 is 3. 2% Then find the price of an 18 month Zero Coupon Bond (Treasury Strip). 13. Name three features that you feel should be included in a Term Structure Model. 14. Describe why some bonds are On Special in the Report Market. 15. State the most useful thing you learned in this course and why you think it is useful.
