1. comm 324 --- W. Suo Slide 1

2. comm 324 --- W. Suo Slide 2  Active strategy Trade on interest rate predictions Trade on market inefficiencies  Passive strategy Control risk Balance risk and return Managing Fixed Income Securities: Basic Strategies

3. comm 324 --- W. Suo Slide 3 Yield Curve Changes  It involves positioning a portfolio to capitalize on expected changes in the shape of the treasury yield curve  Type of shifts in the yield curve: Parallel shift: changes in the yields on all maturities are the same yield change shortintermediate long yield change

4. comm 324 --- W. Suo Slide 4 Yield Curve Change...  Non parallel shifts Twist: flattening or steepening of the yields curve Slope of the yield curve is usually measures by the spread between some long-term treasury and some short term treasury yields, e.g., 30 y over 12 year; 20 y over 2 y yield change Flattening Steepening

5. comm 324 --- W. Suo Slide 5 Yield Curve Change...  Butterfly shift Change in the humpedness of the yield curve: both the yields on the short end and the long change in the same direction, while the yields with intermediate maturities change to an opposite direction yield change

6. comm 324 --- W. Suo Slide 6 Yield Curve Movement: Historical Facts  The three types of movements combined can explain more than 90% of the yield curve changes  They are not independent: downward shift usually combined the steepening of the yield curve upward shift usually combined the flattening of the yield curve

7. comm 324 --- W. Suo Slide 7 Yield Curve Strategy  Yield curve analysis is important if one has a portfolio consisting of many different maturities  Positioning a portfolio with respect to the maturities of the securities across the spectrum included in the portfolio  Common strategies: Bullet strategy: securities in the portfolio are concentrated around one maturity Barbell strategy: concentrated around the extreme ladder strategy: evenly invested in securities with different maturities

8. comm 324 --- W. Suo Slide 8 Example  Bullet portfolio (I): 100% of C  Barbell portfolio (II): 50.2% of A, and 49.8% of B  Duration: I: 6.434; II: 0.502*4.005+0.498*8.882 = 6.434  Dollar convexity: I: 55.4506; II: 0.502*19.8164+0.498*124.1702 = 71.7806  Yield: I: 9.25%, and II: 0.502*8.50%+0.498*9.50% = 8.998% BondCouponMatCash PrYieldMDDollar C’ty A8.551008.54.00519.8164 B9.5201009.58.882124.1702 C9.25101009.256.43455.4506

9. comm 324 --- W. Suo Slide 9 Example …  Yield difference: 9.25%-8.998% = 25.2 b.p.  This is referred to as the cost of convexity: giving up yield for better convexity  Now suppose one has a 6-month investment horizon, which portfolio should he choose: Same duration Yield (I) > Yield (II) Convexity (I) < Convexity (II)

10. comm 324 --- W. Suo Slide 10 Spread Trades  Consider the following bond that has a maturity on 5/15/2034 and the T-note with coupon 5.5% and matures on 11/30/2007 bidaskyieldSDAcc IntPVBP 108.8405108.9037.96%12/2/050.4086541200.643 109.0806109.14137.94%12/3/050.4326921204.999 109.8076109.87017.88%12/4/050.4567311218.246 bidaskyieldSDAcc IntPVBP 100.3735100.43605.30%12/2/050.03022187.3602 1004664100.52895.25%12/3/050.04533187.34 100.5967100.65925.18%12/4/050.06044187.4086

11. comm 324 --- W. Suo Slide 11 Spread Trades  Yield Spread between 30 bond and the two year bond: 7.96%-5.30%=2.66%  What can one do if he believes that yield would be significantly increase (or the slope of the yield curve will increase) in a couple of days? We don’t want to bear the risk of the yield curve having a parallel shift need to make the portfolio’s price risk to be zero: In order for the spread to increase: yield for the 30 year increase relatively more than the 2 year note yield for the 30 year decrease relatively less than the 2 year note How to setup portfolio to realize a profit based on one’s belief?

12. comm 324 --- W. Suo Slide 12 Spread Trades  Relative price would change: 30 year bond would be relatively cheaper than the 2 year note short 30 year bond and long two year note  Assume we want to short $100m par amount of 30 year bond. To eliminate the parallel shift risk, we need to long of par amount 2 year note  Assume that the repo rate using the 2 year note as collateral is 5%, and reverse repo rate using the 30 bond as collateral is 4.9%

13. comm 324 --- W. Suo Slide 13 Trading Spreads … TraderRepo Dealer Trader Deliver two year note Borrow Cash Buy 2 Y note Borrow 30 Y bond Post cash as collateral Sell 30 Y bond ON 12/2/05 TraderRepo DealerTrader ON 12/4/05 Unwind the Position Sell the 2Y note Buy 30Y Bond Payback cash plus int Collect 2Y note Receive Cash plus int Return 30Y bond

14. comm 324 --- W. Suo Slide 14 Summary: On 12/2/2005  Borrow enough cash to buy the $641m par 2Y note (and post it as collateral): (100.4360+0.03022)*10,000*641=(643,988,470) Borrow 30Y bond and sell it (then post the cash as collateral): (108.8405+0.408654)*10,000*100 = 109,249.154 Net Cash Flow: 0 Note: usually repo dealers take haircut

15. comm 324 --- W. Suo Slide 15 On 12/4/04  Sell 2Y note: for the par amount $641m, (100.5967+0.0604)*10,000*641= 645.212,011  Repay the repo dealer: 643,988,470*(1+2*0.05/360)= (644,167,356)  Collect cash plus interest from the repo dealer: 109,249,254*(1+ 2*0.049/360) =109,278,894  Buy the 30Y bond to cover the short position: (109.8701+0.4567)*10,000*100 =(110,326,800) Net:(3,251)

16. comm 324 --- W. Suo Slide 16 Spread Trades  Profit & loss depends on: bid-ask spreads repo rates if the security that is long can earn a special repo rate, which is much higher, then the deal would have made money haircut

17. comm 324 --- W. Suo Slide 17  Substitution swap  Inter-market swap  Rate anticipation swap  Pure yield pickup  Tax swap Active Bond Management: Swapping Strategies

18. comm 324 --- W. Suo Slide 18 Yield Curve Ride Maturity Yield to Maturity % 3M 6M 9M 1.50 1.25 0.75