1. Intermediate Investments F3031 Passive v. Active Bond Management Passive – assumes that market prices are fairly set and rather than attempting to beat the market by using information or insight, the passive manager attempts to maintain an appropriate risk-return trade off or balance –Immunization strategy – A passive strategy to shield net worth from interest rate movements. Used in particular by insurance companies and banks

2. Intermediate Investments F3032 Passive v. Active Bond Management Active – Investors attempt to achieve returns that are more than commensurate with the risk accepted by –Using interest rate forecasts to predict movement in the entire fixed income market –Looking for mis-priced securities relative to one another One of many active strategies is the use of interest rate swaps

3. Intermediate Investments F3033 Immunization – A Passive Strategy Investors face two types of offsetting interest rate risk –Price Risk –Re-investment rate Risk –So, for example, if interest rates rise, the price of your bond will drop, BUT your coupon remains the same and can be re-invested at a higher rate. If the duration of the portfolio is set to the investor’s horizon date, these two risks will exactly cancel each other out. This is only true for small changes in interest rates How does this Immunization strategy accomplish this?

4. Intermediate Investments F3034 An Example Let’s say that you know you will need to have $1,464.10 at the end of 4 years. So, you buy a bond today with a 10% coupon and 5 yrs to maturity. If interest rates remain at 10%, you plan to sell the bond with 1 year left to maturity. Calculate the Duration of this portfolio:

5. Intermediate Investments F3035 What Do you Earn on the Portfolio? ( Assuming you can re-invest at a 10% rate)

6. Intermediate Investments F3036 What if the Yield Changes to 11% (the bond orice falls, but the reinvestment rate rises)

7. Intermediate Investments F3037 Problem Faced by Banks Liabilities (customer deposits) are short term and have a low duration. Assets (loans) are long-term and have a higher duration. –So, if interest rates rise, assets fall in value by more than the decrease in liabilities –Banks try to match the duration of assets and liabilities

8. Intermediate Investments F3038 Constructing an Immunized Portfolio Assume that a company has a liability due in 3 years = $19,487 Market Rate of Interest = 10% Present value of the obligation = $10,000 The goal is to fund this with assets that have a duration of 7 years using 3yr zero coupon bonds and a 10% bond with annual coupons. –What is the duration of a zero coupon bond? –What is the duration of the coupon bond? –What are the weights for both assets? –What happens one year from now, assuming no change in interest rates?

9. Intermediate Investments F3039 Constructing an Immunized Portfolio Calculate Duration of a 10% coupon bond, interest paid annually that matures in 15 years

10. Intermediate Investments F30310 Constructing an Immunized Portfolio Calculate Duration of a 10% coupon bond, interest paid annually that matures in 14 years

11. Intermediate Investments F30311 Active Bond Management Active Bond Management has two sources of value –Interest Rate Forecasting If a decline is predicted, managers increase duration If an increase is predicted, managers shorten duration –Identify relative mis-pricing Only if information is not already commonly known

12. Intermediate Investments F30312 Active Bond Management (cont) Five types of bond swaps to re-balance a portfolio –Substitute swap –Inter-market spread swap –Rate anticipation swap –Pure yield pickup swap –Tax swap

13. Intermediate Investments F30313 Interest Rate Swaps Interest rate swaps are contracts between two parties to trade the cash flows corresponding to different securities without actually exchanging the securities directly. It is a means to measure interest rate risk

14. Intermediate Investments F30314 Interest Rate Swaps: An Example You have a $100M portfolio with an average coupon rate of 7% AND you believe interest rates will change. How do you take advantage of rising rates? Falling rates?