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Investment fundamentals exercise with solutions

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Investment Fundamentals

Professor Lucie Teplá

CA01

AUT18

Exercise #2:

Curve Trades

Curve Trades

• Want to set up a position:

- consisting of two bonds with different maturities

- where you are long one bond, short the other

- that will be unaffected by small parallel shifts of the yield curve

(duration-neutral)

- will make money if yield curve flattens

• Assume you have the following 2 bonds (both with face value $1,000):

A: 2-year 2.375% 2.5% 997.59 1,923.91 1.9286 1.9768

B: 10-year 2.75% 2.95% 982.90 8,464.6.1 8.6119 8.8660

2

Price and Duration Calculations

Bond A Bond B

coupon 2.375 coupon 2.75

yield 2.5 yield 2.95

t CF PV(CF) t*PV(CF) t CF PV(CF) t*PV(CF)

1 23.75 23.1707 23.170732 1 27.5 26.712 26.711996

2 1023.8 974.42 1948.84 2 27.5 25.9466 51.893144

997.591 1972.0107 3 27.5 25.2031 75.609244

Price 1,923.91 $D 4 27.5 24.4809 97.92358

1.9286 D_MOD 5 27.5 23.7794 118.89701

1.9768 D_MAC 6 27.5 23.098 138.58807

7 27.5 22.4361 157.05301

8 27.5 21.7932 174.34595

9 27.5 21.1688 190.51889

10 1027.5 768.278 7682.7787

982.896 8714.3196

Price 8,464.61 $D

8.6119 D_MOD

8.8660 D_MAC

3

Curve Flattener

• Which bond do you buy, which one do you short?

3.0%

Bond B

yield

2.5%

Bond A

2.0%

1.5%

0 2 4 6 8 10 Source: ft.com

maturity

4

Curve Flattener

• Long the 10 yr bond (B), short the 2 yr bond (A)

• Assume you buy 1 unit of Bond B, in order to be duration hedged, solve:

nB = 4.40

$Duration neutral

ie short 4.40 units

nA · 1923.91 + 1 · 8464.61 = 0 of bond A

nA · $DA + nB · $DB = 0

• Net cost (receive money, which you lend out):

⇡ 4903.36 · (· 997.59

yB ⇡ [ $DA · yA ] 2.920 [ $DB · yB ]

982.90 4.40 =yA )3, 406.19

nA = 4.40

⇤ ⇤

⇡ 4903.36 · [0.02 (yA⇤ yB⇤ )] ⇡ 4903.36 · [(yB yB ) (yA yA )]

nA · $DA + nB · $DB = 0 5

· 1923.91

nA P 4.88+ 1 · 8464.61 = ⇡ 0 4903.36 · [0.02 (yA⇤ yB⇤ )]

= = 4, 880

y 0.001

⇡ 4.40 · [ $DA · yA ] + 1 · [ $DB · yP B] =

4.88

= 4, 880

P/P P 1 4.88/1092.46

= · = = 4.475 y 0.001

Curve Flattener

y y P

⇡ 8464.61 · ( yA

0.001

yP/P

B) P 1 4.88/1092.46

1 X T = · = = 4.475

$D = ⇤

t · P V (CFt ) y y P 0.001

• Overall position:⇡ 8464.61(1 + y) t=1⇤

· [(yA yA ) (yB⇤ yB )] T

1 X

X T

P V ⇤ (CFt ) $D = t · P V ⇤ (CFt )

DM ACPrice

= per t· $Duration (1 + y)

$Duration

t=1

Number⇡ 8464.61 · [(y $y Invested

P ) (y ⇤

y ⇤

)]

bond

t=1 B A B per bond

A ofT position ⇤

X P V (CFt )

A: 2-year -4.40 1 dP997.59 1 X -4,389.4

T ⇤ D

1923.9

M AC = t·

-8,464.6

P V (CFt ) P

B: 10-year DM OD = ⇡ =

8464.61

+1 P dy982.90 · [0.02 t ·

(y

982.90

⇤

y ⇤

)]

t=1

(1 + y) t=1 B PA 8464.6 8,464,6

T

Cash - - 3,406.2D 0 1 dP 01 X P V ⇤ (CFt )

1 + nominal M OD = = t·

BE inflation =

Net

P yield 4.88 1 =0 1.0244 1 = 2.09% P dy (1 0+ y) t=1 P

=

1+ realy yield = 4, 880

1.0044

0.001 1 + nominal yield 1.0244

1 + r BE inflation =

1.0244 1= 1=

• Each bond leg (long/short)

P/P

BE inflation == P has

1 1=$Duration

4.88/1092.46 of 8,464.16

1 == 2.09% 1+ real yield 1.0044

y 1+y z· P = 1.0044 0.001

4.475

• Therefore for a 1bps flattening, earn 8,464.16 x 0.0001 = $0.846 1+r 1.0244

BE inflation = 1 = 1 = 2.09%

T @P 1 1+ z 1.0044

Modified Duration 1 X = · ⇤

$D = t @y

· PV P (CFt )

(1 + y) t=1 @P 1

Modified Duration = ·

r ⇡ z + i ) i ⇡ r z =X 2.44%

T 0.44% = 2.00% @y P

P V ⇤ (CFt )

DM AC = t· 6

t=1 r P⇡ z + i ) i ⇡ r z = 2.44% 0.44% = 2.00

= 0.41% 2.85%

T

1 dP 1 X P V ⇤ (CFt )

DM OD = = t· = 0.41% 2.85%

Curve Flattener

• Therefore, for small moves in yields:

- If yields move up and down together by the same amount, no change

in value

- If yield difference decreases (yield curve flattens) you make money,

specifically $0.846 for every 1bp flattening

- If yield difference increases (yield curve steepens) you lose money .

specifically $0.846 for every 1bp steepening

In the News...

8

In the News...

In the News...

10

Curve Flattener

• What happens if the yield difference stays the same but yields move by a

larger amount?

• Value of the position (long bond B, short 4.40 bond A plus 3,406.20 cash):

16

P&L ($)

13.69

12

11.29

0

-3% -2% -1% 0% 1% 2% 3%

Amount all yields move by

11

Curve Flattener

• Positive P&L comes from different convexities (curvatures) of the two

bonds, specifically Bond B has higher convexity than position in Bond A:

1400

Bond B Value ($)

1200

4.4 units Bond A - $3,406

1000

800

600

-6% -4% -2% 0% 2% 4% 6%

12

Curve Flattener

• Convexity is approximately the weighted average time squared to

cashflows (weights equal to contribution of PV of cashflow to total price)

- Details see Appendix (not required material)

• Therefore overall position has positive convexity

• Positive convexity (while being duration hedged) means you have positive

P&L for large (parallel) moves in yields

13

Appendix – Convexity

(not required material)

Convexity

• Convexity is a measure of :

- the curvature in the relationship between bond prices and yields

- how interest rate/yield sensitivity (duration) changes with yields

1000"

if rates decrease by 800" $D=12,000

100bps

$D=8,894

600"

$D=6,611

increase by 100bps

200"

0"

0%" 2%" 4%" 6%" 8%" 10%"

15

Interest rate/yield

Convexity

MFIN Financial Markets Credit Markets

INSEAD February 2015

• TwoMarkets

MFIN Financial basic types (defined with respect to yields): Credit Markets

INSEAD - Dollar Convexity ($Conv): February 2015

d2 P d$D

$Conv = 2

=

dy

d2 P dy

d$D

$Conv = =

dy 2 dy

- Normal or “Relative” Convexity (Conv):

= $DA · (0.08 yA ) 2.920 · $DB · (0.06 yB ) = 4903.364 [(0.08 0.06) (yA yB )]

$Conv 1 d2 P

Conv = =

P P dy 2

4903.364 + nB · 1679.239 = 0 or

= $DA · (0.08 yA ) 2.920 · $DB · (0.06 yB ) = 4903.364 [(0.08 0.06) (yA yB )]

4903.364 + nB · 1679.239 = 0 or

16

pf A B

$D = nA · $D + nB · $D

pf nA·P4.488

1092.458 A + nBA · 889.996 · n

1.8868

B PB = 0 B

X T CFt X T

P =X CFt t = X P V ⇤⇤ (CFt ) $Dpfpfpf==nnAA· ·$D

$D $DAAA++nnBB· ·$D

$DBBB

P = t=1 (1 + y)t = t=1 P V (CFt ) $D = nA · $D + nB · $D

t=1 (1 + y) t=1 n nAAPPAA nnBBPPBB

pfpf AA BB

XT $D $DM OD == n P · D

· DM OD + + n P · ·DDM OD

1 XT ⇤$D

M OD

pf

=

A A M OD

A B B

nnAAPPAA++nnBBPPBB · DM OD +nnAAPPAA++nnBBPPBB · DM M

B OD

$Conv = 1 t(t + 1) · P V ⇤ (CF

M OD

t ) n A PA + n B P B n A P A + n B PB OD

$Conv = (1 + y)22 t=1 t(t + 1) · P V (CFt )

Convexity – Expressions

(1 + y) t=1

T AA BB

1 X

XT P V ⇤⇤ (CFt ) ==wwAA· ·DDM OD ++wwBB· ·DDM OD

Conv = 1 t(t + 1) · P V (CF t ) = w · D

M

A OD

+ w · D BM OD

Conv = (1 +Zero 2

y) 2 t=1 t(t + 1)

Coupon Bond P · P A

Coupon Paying Bond M OD B M OD

(1 + y) t=1

XTX

T XTXT

F CFCFt t

P = F PP== XT

CF == XPPVV⇤ (CF

T ⇤

(CFt )t )

P = (1 + y)TT P =t=1 (1(1++ t

y)y)t t

= P V ⇤

(CF

(1 + y) t=1 t

t=1

t=1 t)

t=1 (1 + y) t=1

T (T + 1) 11 X TX T

$Conv = T (T + 1) ·P $Conv =

$Conv = Xt(t

T t(t++1)1)· ·PPVV⇤⇤(CF⇤

(CFt )t )

$Conv = (1 + y)22 · P (1 + 1y) 2 2

(1 + y) $Conv = (1 + y) t=1t=1t(t + 1) · P V (CFt )

(1 + y)2 t=1

TX

11 X T PPVV⇤ (CF

⇤

(CFt )t )

Conv

Conv== 1 X T t(t

t(t + + 1)

1)· · P V ⇤

Conv =

T (T + 1) 2

Conv = (1(1++y)y)22t=1 t=1t(t + 1) ·

PP t )

(CF

(1 + y)2 (1 + y) t=1 P

FF

T

X T

X

PP== Fy)T T

CFt ⇤ P = (1(1++ y)

P = t

= P V (CFt ) (1 + y) T

t=1 (1 + y) t=1

… (approx) weighted average squared time to Treceiving

T(T(T++1)1)cashflows

$Conv

$Conv == T (T + 21)2 · ·PP

dP 1 X T

$Conv = (1(1++y)y)2 · P

$D = = t · P V ⇤ (CFt ) (1 + y) 17

dr (1 + y) t=1

T

1 dP 1 X P V ⇤ (CFt )

$DM OD = = t·

P dr (1 + y) t=1 P

T

Using Convexity

(1 + y) dP X

to P V ⇤ (CFt )

Approximate Price Changes

AC = (1 + y) · D M OD = = t ·

P dy t=1 P

MFIN •Financial

Convexity can be used to give a better estimation of bond price changes

Markets Credit as

Markets

F

interest rates 1000

change

INSEAD

P = = February 2015

(1 + r) T (1 + r) 10

MFIN Financial Markets change in price, DP, for a small change in interest

- Approximate ratesMarkets

Credit

INSEAD Dy:

dP F February 2015

$D = =T· T +1 1

dr (1 + P r)⇡ $D · y + · $Conv · ( y)2

2

1000 1

= 10 · =P 5, ⇡

846.79$D · y + · $Conv · ( y)2

r)11 r=0.05 P % change in price, DP/P:

(1-+Approximate 2 1

⇡ DM OD · y + · Conv · ( y)2

P 2

1 dP 1 P F T 1 2

$DM OD = = · T · P ⇡T +1 D =M OD · y + 2 · Conv · ( y)

P dr P (1 + r) (1 + r)d2 P d$D

$Conv = =

dy 2 dy

10 d2 P d$D

= = 9.52 $Conv = =

1.05 dy 2 dy

$Conv 1 d2 P 18

Conv = =

P P dy 2

1000 1000 $Conv 1 d2 P

P = = Conv = =

(1 + r )T (1 + y)T 2

Using Convexity to Approximate Price Changes

• For example, approximating bond price changes for the 30-yr ZCB:

1000"

600"

Approximation

using Duration only 400" Approximation using Duration

and Convexity

200"

0"

0%" 2%" 4%" 6%" 8%" 10%"

Interest rate/yield

19

Properties of Convexity

• Basic properties:

- coupon and yield constant, Conv increases with time to maturity

- maturity and yield constant, Conv is higher the lower the coupon

- coupon and maturity constant, Conv is higher the lower the yield

• Portfolio aspects:

- $Conv of a portfolio is given by weighting the $Conv of the individual

bonds by the number of units held

- Conv of a portfolio is given by market-value weighting the Conv of the

individual bonds

20

Convexity Example

• Consider the 6yr 10% annual coupon bond with yield of 8% from Session #2:

t CF PV*(CF) at 8% t times PV*(CF) t (t+1) PV*(CF)

1 100 92.59 92.59 185.19

2 100 85.73 171.47 514.40

3 100 79.38 238.15 952.60

4 100 73.50 294.01 1,470.06

5 100 68.06 340.29 2,041.75

6 1100.00 693.19 4159.12 29,113.84

Sum 1092.46 5295.63 34,277.83

Price 1092.46

$ Duration 4903.36

Mod Duration 4.49

Mac Duration 4.85

$Convexity 29,387.72 = 34,278/1.082

Convexity 26.90 = $Conv/Price

21

Convexity Example

• Convexity of bonds in curve flattener trade:

Modified

Coupon Yield Price $Duration $Conv Conv

Duration

A: 2-year 2.375% 2.5% 997.59 1923.91 1.929 5608.91 5.622

B: 10-year 2.75% 2.95% 982.90 8464.61 8.612 168,928 171.87

• In summary:

- Duration-neutral: hedged against small (parallel) moves in yields

- Positive convexity: positive P&L if large (parallel) moves in yields

22

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