Bond Pricing and the Term Structure of Interest Rates - Heath-jarrow-morton
1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term...
-
Upload
abigail-paul -
Category
Documents
-
view
226 -
download
0
Transcript of 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term...
![Page 1: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/1.jpg)
1
Bond Portfolio Management
Term Structure Yield Curve Expected return versus forward rate Term structure theories
Managing bond portfolios Duration Convexity Immunization and trading strategy
![Page 2: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/2.jpg)
2
The relationship between yield to maturity and maturity.
Information on expected future short term rates can be implied from yield curve.
The yield curve is a graph that displays the relationship between yield and maturity.
Three major theories are proposed to explain the observed yield curve.
Overview of Term Structure
![Page 3: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/3.jpg)
3
Figure 15.1 Treasury Yield Curves
1). Pure yield curve; 2). on-the-run yield curve (page 485)
![Page 4: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/4.jpg)
4
Table 15.1
1-year rate is 5%, 2-year rate is 6%, 3-year rate is 7%, 4-year rate is 8%. Compute the yield to maturity of a 3-year coupon bond with a coupon rate of 10%.
![Page 5: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/5.jpg)
5
11)1(
)1()1(
n
n
nn
n y
yf
fn = one-year forward rate for period n
yn = yield for a security with a maturity of n
)1()1()1( 11 n
nn
nn fyy
Forward Rates from Observed Rates
![Page 6: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/6.jpg)
6
Example: page 487
4 yr = 8.00% 3yr = 7.00% f4 = ?
![Page 7: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/7.jpg)
7
Downward Sloping Spot Yield Curve
Zero-Coupon Rates Bond Maturity12% 111.75% 211.25% 310.00% 49.25% 5
![Page 8: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/8.jpg)
8
Forward Rates Downward Sloping Y C
1yr Forward Rates
1yr= = 0.115006
2yrs= = 0.102567
3yrs= = 0.063336
4yrs= = 0.063008
![Page 9: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/9.jpg)
9
Expectation Theory Forward rate = expected rate (page 494)
Liquidity Premium Theory Upward bias over expectations Equation 15.8 on page 499
Theories of Term Structure
![Page 10: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/10.jpg)
10
Figure 15.4 Yield Curves
![Page 11: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/11.jpg)
11
Figure 15.4 Yield Curves (Concluded)
![Page 12: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/12.jpg)
12
Figure 15.6: Term Spread
![Page 13: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/13.jpg)
13
A measure of the effective maturity of a bond. The weighted average of the times until each payment is received,
with the weights proportional to the present value of the payment. Duration is shorter than maturity for all bonds except zero coupon
bonds. Duration is equal to maturity for zero coupon bonds.
Duration
![Page 14: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/14.jpg)
14
Figure 16.2 Cash Flows Paid by 9% Coupon, Annual Payment Bond with an 8-Year Maturity and 10% Yield to
Maturity
![Page 15: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/15.jpg)
15
t tt
w CF y ice ( )1 Pr
twtDT
t
1
CF Cash Flow for period tt
Duration: Calculation
![Page 16: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/16.jpg)
16
Example: Duration
See page 516-517.
![Page 17: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/17.jpg)
17
Price change is proportional to duration and not to maturity.
P/P = -D x [(1+y) / (1+y)
D* = modified duration
D* = D / (1+y)
P/P = - D* x y
Duration/Price Relationship
![Page 18: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/18.jpg)
18
Rules for Duration
Rule 1 The duration of a zero-coupon bond equals its time to maturity.
Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate is lower.
Rule 3 Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity.
Rule 4 Holding other factors constant, the duration of a coupon bond is higher when the bond’s yield to maturity is lower.
Rules 5 The duration of a level perpetuity is equal to: (1+y) / y
![Page 19: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/19.jpg)
19
Figure 16.3 Bond Duration versus Bond Maturity
![Page 20: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/20.jpg)
20
Correction for Convexity
n
tt
t tty
CF
yPConvexity
1
22
)()1()1(
1
Correction for Convexity:
])([21 2yConveixityyD
P
P
![Page 21: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/21.jpg)
21
Figure 16.5 Convexity of Two Bonds
Which bond does you prefer?
![Page 22: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/22.jpg)
22
Figure 16.6 Price –Yield of a Callable Bond
Negative convexity: page 526; mortgage has the similar feature (page 526, 528)
![Page 23: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/23.jpg)
23
Bond-Index Funds Lehman Aggregate Bond index Salomon Smith Barney Broad Investment Grade (BIG) Index Merrill Lynch U.S. Broad Market Index
Immunization of interest rate risk: Net worth immunization
Duration of assets = Duration of liabilities Target date immunization
Holding Period matches Duration
Cash flow matching and dedication Covered in fixed income class
Passive Management
![Page 24: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/24.jpg)
24
Immunization
Price risk Reinvestment Immunization is the point that two effects are
cancelled out.
![Page 25: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/25.jpg)
25
The key idea is to predict the interest rate movement
Or simply riding on the yield curve
Active Management: Swapping Strategies
![Page 26: 1 Bond Portfolio Management Term Structure Yield Curve Expected return versus forward rate Term structure theories Managing bond portfolios Duration Convexity.](https://reader036.fdocuments.net/reader036/viewer/2022062321/56649ed25503460f94be201d/html5/thumbnails/26.jpg)
26
Maturity
Yield to Maturity %
3 mon 6 mon 9 mon
1.5 1.25 .75
Yield Curve Ride