FINA 3080

Investment Analysis and

Portfolio Management
Prof. Chao Ying
Lecture 4A
The Yield Curve and Credit Spread
-

FINA 3080 Prof. Chao Ying 1

 Lecture 4A Outline

• Interpreting the yield curve: provide information

about the future economy

• Default risk, ratings and bond yields

FINA 3080 Prof. Chao Ying 2

 Overview of Term Structure
• Term structure of interest rates: relationship
between YTM and maturity.

• The yield curve is a graph that displays the term

structure of interest rate

• Information on expected future interest rates

can be implied from yield curve.

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 Treasury Yield Curves

Common

✗
similar
YTM

• Rising yield curves are most commonly observed.

• Why 4 different patterns: Expectations Theory and Liquidity Theory

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 Expectations Theory

• Definition: YTM is only determined by expectations of

future short-term interest rates.
• Example. Current 1-year interest rate: 8%
• Next Year: investors expect it will rise to 10%

• Two-year bonds offer yields 8.995%: upward sloping

Mmm

• If next year’s interest rate < 8%: downward sloping

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 Forward rates
• Forward rate: the second-year interest rate that makes
the following two strategies equal:
1. Hold the 2-year bond directly
2. Buy 1Y bond; roll the proceeds into another 1-Year

1.08995! = 1.08 ∗ (1 + +! )
Which implies the forward rate is +! = 10%.
• Extend to equating the return on year n:
(1 + yn)n = (1 + yn-1)n-1(1 + fn)
↑
1 bond on
year year n

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 Example of Forward Rates
• 3-year YTM y3=7%; 2-year YTM y2=6%
• Two equivalent 3-year strategies
• Buy a 3-year zero
• or buy a 2 year zero and roll over into 1 year
zero at year 2 at forward short rate f3
• (1+y3)3=(1+y2)2 * (1+f3) f3=9.02%
•(1+yn)n=(1+ym)m * (1+f)n-m ; where ! > #

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 Liquidity Theory
• Investors will demand a premium for the risk
associated with long-term bonds
• Short-term bonds have more liquidity:
– Less price uncertainty ( can predict what happen in short future)

– Trade more frequently with lower bid-ask spread

=
• Liquidity premium: compensate to long-term
– spread between forward rate and expected short rate
• The yield curve has an upward bias even when
rates are expected to remain unchanged!
-

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 Why Would the Curve Slope Up?
• Investors expect short rates to rise in the future
– Economic growth (demand for capital is rising)
↳ r%8
– Inflation is getting out of control
• Real rates will go up; and/or inflation will rise
• Investors prefer short-term bonds (and
borrowers don’t) even
• Marginal investor is a “speculator” (or needs cash now)
• Firms have long-term projects with delayed payoffs
will / By Expectation theory)
If downward sloping recession come

FINA 3080 Prof. Chao Ying 9

flat expect
: bad Treasury Yield Curves
economy , but notinverted yield curve
↓ as bad as

w-
liquidity expectation
theory theory
edtpeited
[economy
"

• The combinations of both Expectations Theory and Liquidity Theory

• Inverted yield implies falling interest rates: indicates a coming recession.

FINA 3080 Prof. Chao Ying 10

 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 4B
Interest Rate Sensitivity
_

FINA 3080 Prof. Chao Ying 11

 Lecture 4B Overview
• Bond Pricing Relationships
Prof all future cfs
.

T = maturity
Coupon Par Value
Bond Price = å +
t =1 (1 + r ) t
(1 + r )T

• Find Zero prices at different interest rates

• Define a general measure of rate sensitivity
– Illustrate the features of duration
– Duration, modified duration, and price change
– Convexity
– Rules of duration
FINA 3080 Prof. Chao Ying 12
 Zero Prices at Different Rates
• Consider a Zero maturing in year T
• Use the bond pricing equation to get the price
– PV of $1,000 par payment: Price = $1,000 / (1 + y)T
• If interest rates are 0%, then price = $1,000
• If rates go up to 2%, then price depends on T
∆"
– When T is 3 years, price is roughly $940, = −6%
"
∆"
– When T is 5 years, price is roughly $900, = −10%
"
→
– Larger maturity has larger price sensitivity
FINA 3080 Prof. Chao Ying 13
 The General Rate Rule for Zero Prices
e-
↳
Ey
= -

• Denote the price by P

– P = Par / (1 + y)T= Par * (1 + y)-T
– dP = -T*Par * (1 + y)-T-1 *d(1+y)
– dP = -T*P * (1 + y)-1 *d(1+y) = -T*P *d(1+y)/(1 + y)
– dP/P = -T*dy/(1 + y)
– %(Price chg) = -Maturity * %(Discount rate chg)
• Price sensitivity for Zero is captured by maturity
(go back to the previous slide)
• We can use the Zero rule to obtain a general rule
FINA 3080 Prof. Chao Ying 14
 Par value
p= (
Kyi
dᵈ¥y City -5
" '

= Par ✗ 1- 7) ✗

,
"'

Px ( Hy ) -1×1--4
?y
-

=
✗ ( Hy )
,
"

=P x
-

T ✗ ( Hy )

duty
¥ =
-
t ×

Hy
% change
( linear approximation )
%
= -

T ✗ change in

in Price discount rate

 Rate Sensitivity of a Portfolio of Zeros
• Replicate: coupon bond is a portfolio of Zeros
– Portfolio weights depend on the bond’s cash flows

• Portfolio sensitivity to rates

– Weighted average of the sensitivity of the Zeros

• Coupon bond duration= Portfolio sensitivity

• Use the bond duration to estimate price changes

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 Bond Duration Formula
• Duration D: effective maturity of bonds
– The weighted average of the times until each
payment is received
• The weights wt proportional to the present value
of the payment.
T
CFt /(1 + y)t
D = å t ´ wt wt =
t =1 Bond Price
• Duration is shorter than maturity for all bonds
except zero coupon bonds.
– Duration is equal to maturity for Zeros.
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Cash Flows Paid by 9% Coupon, Annual Payment Bond
with an 8-Year Maturity and 10% YTM

CFt /(1 + y)t T

wt = D = å t ´ wt
Bond Price t =1

i;÷
¥ . -
- - -
-
-
- -

Year 1 2 3 4 5 6 7 8
Pay 90 90 90 90 90 90 90 1090
PV Bond price
weight
Duration Total Duration

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Cash Flows Paid by 9% Coupon, Annual Payment Bond
with an 8-Year Maturity and 10% YTM

T
CFt /(1 + y)t
wt = D = å t ´ wt
Bond Price t =1

Year 1 2 3 4 5 6 7 8
Pay 90 90 90 90 90 90 90 1090
PV 81.82 74.38 67.62 61.47 55.88 50.80 46.18 508.49 946.65
weight 0.09 0.08 0.07 0.06 0.06 0.05 0.05 0.54
Duration 0.09 0.16 0.21 0.26 0.30 0.32 0.34 4.30 5.97

FINA 3080 Prof. Chao Ying 18

 Duration/Price Relationship
• Price change is proportional to duration and Onot to maturity.
-

D P/P = -D x [D(1+y) / (1+y)]

• Modified duration describes a percentage change in bond price
with respect to the yield change
D* = modified duration = D / (1+y)
D P/P = - D* x D y D int rate 0 bond
prie

• Duration rule underestimates the bond price b/c of convexityuh

– Recall that derivatives are only local approximations

– The rule works best for small changes in rates
– Larger interest rate change will generate larger error

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 Visualizing Convexity
Price

Pricing Error from

Convexity

Duration

Yield

FINA 3080 Prof. Chao Ying 20

 Convexity: Estimated and Actual Price change
$"%&!'()!*
,-./-0 67897:.;
Bond Price = +
(1 + 4)!
+
(1 + 4)$ D P/P = - D* x D y
!"#

i. Duration underestimates
A bond prices
DP
B
P Δy>0
-D*

-D*
Δy<0 C

Δy
FINA 3080 Prof. Chao Ying 21
 Bond Convexity
• Relationship between bond prices and yields is not linear

• Rate sensitivity (duration) changes with YTM

– Convexity captures this idea (if linear, duration is constant)

• Convexity is important for large rate changes

• Bonds generally have positive convexity

– Preferred by investors: An increase in a bond’s YTM results in
a smaller price decline than the gain associated with a decrease
– Duration rule underestimates the bond price
FINA 3080 Prof. Chao Ying 22
 Bond Duration in Practice
$"%&!'()!*
,-./-0 67897:.;
Bond Price = +
(1 + 4)!
+
(1 + 4)$
D P/P = - D* x D y
!"#

• Example of annual coupon bond:

– 2-year 10% bond with initial YTM of 10%
– Price = $1,000 initially
– Duration is 1.909 years
:
¥ -"%
– If rates go up to 11%, then price falls to $982.87 i:*
• Modified duration is 1.909/1.1=1.735 years
Cal

using )
– Estimated price with duration is $982.65: error=22c 1cal
– Where 982.65=1000-1000*1.735*1%. % D

– If rates fall to 9%, then price goes up to $1,017.59s

– Estimated price with duration is $1017.35: error=24c
– Here YTM only change 1%. Higher Error if higher change.
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 Summary of Duration
• Three key interpretations

– Definition: interest rate sensitivity of a bond

– Weighted average of time until cash flows received

– Tool for measuring and eliminating interest risk

(next slide)

FINA 3080 Prof. Chao Ying 24

 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 4C
Duration and Immunization
-

FINA 3080 Prof. Chao Ying 25

 Lecture 4C Overview
• Passive bond management: immunization
↓
• Discuss portfolio immunization need to faceno
rate
– Immunization of interest rate risk any future
interest
it modified bond duration
– (modified) duration of assets =modified liab duration
.

= (modified) duration of liabilities

• Show how duration changes
– When time changes
– When YTM changes

FINA 3080 Prof. Chao Ying 26

 Duration and Immunization
• Immunization is a dynamic portfolio managing strategy
that allows to meet a set of liabilities out of proceeds
from a self-financing bond portfolio
• Some firms want to reduce interest rate risk
– e.g. bank and pension fund
O int rate risk
• They can buy or sell bonds
.

achieved
by :

– With matching (modified) durations

✓
• Interest rate risks cancel for immunized portfolios when
(modified) bond duration = (modified) liability
maturity immunized if 4¥ see :

When ask : whether firm is

FINA 3080 Prof. Chao Ying 27

 Portfolio Immunization
• Portfolio managers have assets and liabilities
– Often their values are close to equal
• Can set asset duration equal to liability duration
– This policy minimizes overall interest rate risk
• Method 1: Look for a single bond with target D 4 ration

• Method 2:( Combine

Portfolio )
long- and short-term bonds
• Compare the modified durations
– use duration if interest rates are same for both sides

FINA 3080 Prof. Chao Ying 28

 Example (1)
• Pension fund offers a $10 mln 5-yr 8% GIC
– Liability duration is 5 years I int rate
.

– Invests in 7-yr 10% bonds at YTM 12.92%

– Is the fund immunized now?

É÷É% FINA 3080 Prof. Chao Ying 29

 Duration Changes (Passive Mgmt)
• A bond’s duration changes as each year passes
– Zeros duration falls by one year
- =

– Perpetuity duration does not fall as time passes

– Coupon bond duration falls by less than one year

• A bond’s duration changes as rates change

– For normal (positively convex) bonds
• Duration goes up when rates go down
rated →
D8
FINA 3080 Prof. Chao Ying 30
 Immunization Rebalancing
• Rebalance when a mm significant difference in durations
between liabilities and immunization portfolio occurs

– Changes in interest rates

– Payments made by immunization securities
– Liabilities been paid off

• Continuous rebalancing is not feasible: transaction costs.

FINA 3080 Prof. Chao Ying 31

 Example (2a): Zeros
• Pension fund has $100m PV obligations after 8 years
– Assume YTM are the same on both sides
– Only 2-year and 10-year zeros are available now
– So invest w% of $100m on 2-year zeros and (1-w%) of
$100m on 10-year zeros
– Set w%=25% such that portfolio has duration=8
– fund is immunized now
• What will happen after 1 year?
– New obligation duration becomes 7
– New portfolio duration is 25%*1+75%*9=7
– No rebalance is required
FINA 3080 Prof. Chao Ying 32
 Example (2b): Zeros+ perpetuity
• Pension fund has $100m PV obligations after 8 years
– Assume YTM=10% are the same on both sides
– Only 2-year and perpetuity are available now
– w* 2 years + (1-w)* (1+0.1)/0.1 = 8
– Set w=1/3 such that portfolio has duration=8
– fund is immunized now
• What will happen after 1 year?
– New obligation duration becomes 7
– New portfolio duration is w*1+ (1-w)* 11=7
– w=0.4 and rebalance is required

FINA 3080 Prof. Chao Ying 33

Modified duration: different YTMs
• Pension fund has $20m PV obligations after 5 years
with 10% interest rate.

– Only 2-year and 8-year zeros are available now,

priced at YTM 20%

• How to invest on 2-year and 8-year zeros?

FINA 3080 Prof. Chao Ying 34

 Modified duration: different YTMs
• Pension fund has $20m PV obligations after 5 years
with 10% interest rate.
– Only 2-year and 8-year zeros are available now,
priced at YTM 20%
• How to invest on 2-year and 8-year zeros?
modified
↓ durations ↓

00
"! "" (∗#.! *%
• = → 0' = = .
#$%.# #$%.! #.# ##
!+
• 1 ∗ 2 + 1 − 1 ∗ 8 = 0' → 1 = **
!+ !+
• $205 ∗ ** 2-year zeros; $205 ∗ 1 − ** 8-year zeros
FINA 3080 Prof. Chao Ying 35
 Lecture 4: Assignments
• Review chapter 10 & 11
• Read chapter 13.1-4
– Practice problems:
• PS: Ch. 13 (1-3, 6, 9-11, 18-20, 23)
• CC: Ch. 13 (1-3, 5)
• Work on Problem Set #1
– Due by 11 am on October 12th, 2022 (Wednesday).
– Please submit on BB.
– One group only needs to submit once. Write down group
members’ name & SID.

FINA 3080 Prof. Chao Ying 36