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Level III Yield Curve Strategies Summary 1 Graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute.. Major Types of Yield Curve Strategies 1/2 Active strategie

Level III

Yield Curve Strategies

Summary

1

Graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute

Reproduced and republished with permission from CFA Institute All rights reserved

Major Types of Yield Curve Strategies (1/2)

Active strategies under assumption of a stable yield curve

Buy and hold Build portfolio with characteristics different from benchmark; minimize trading over

investment horizon

Roll down (ride)

yield curve

Works with upward sloping yield curve As bond ages  yield down  price up

Target steep portion of yield curve  significant price appreciation

Sell convexity If yields are stable then convexity does not help  sell convexity

Sell options or buy callable bonds and MBS

Carry trade Buy securities with high yield and finance with low-yield securities

Major Types of Yield Curve Strategies (2/2)

Active strategies for yield curve movement of level, slope, and curvature

Duration

management

% P change ≈ –D × ∆Y (in percentage points) Duration management methods:

• Number of futures contracts = Required additional PVBP / PVBP of the futures contract

• MV of purchased bonds = (Additional PVBP / Duration of bonds to be purchased ) x 10,000

• Effective portfolio duration ≈ (Notional portfolio value / portfolio equity ) x duration

• Notional value of swaps = Additional PVBP / PVBP of swap How the duration is changed does matter

Bullet and

barbell

structures

Bullets target a single segment of the yield curve; barbells target short and long yields Bullet structures do well when yield curve steepens

Barbell structures do well when yield curve flattens

Buy convexity If yield is expected to change  add convexity

Higher convexity bonds are more expensive (lower yield) Convexity can be bought by 1) altering portfolio structure or 2) buying call options

Altering Portfolio Convexity

Make structure more barbelled Make structure more bulleted

Buy options Sell options

Buy callable bonds Buy mortgage backed securities

Portfolio Positioning Strategy Given Forward Rates and

Interest Rate View

Upward sloping yield curve

which will remain stable

Roll down the yield curve

Parallel shift up Lower duration

Parallel shift down Higher duration

High interest rate volatility Add convexity

• Buy options

• More barbelled structure

If yield change does not materialize the higher convexity will cause a yield drag Low interest rate volatility Sell convexity

• Sell options

• More bulleted structure Flatter yield curve Barbell

Steeper yield curve Bullet

Use of Derivatives to Implement Yield Curve Strategies

Altering Duration

• Number of futures contracts = Required additional PVBP / PVBP of the futures contract

• Notional value of swaps = Additional PVBP / PVBP of swap

Altering Convexity

To add convexity of portfolio:

• Sell bonds and buy options

 Par value of options needed = Par value of bonds being sold x (bond’s PVBP / option’s PVBP)

To reduced convexity of portfolio:

• Sell options

• Replace regular bonds with callable bonds or MBS

Evaluating Sensitivity to Changes in Slope using KRDs

Key rate durations (KRD, partial durations) measure duration at key points on the yield curve

• Used to identify bullets and barbells

• Sum of KRDs ≈ effective duration

Predicted change = Portfolio par amount × Partial PVBP × (–Curve shift)

Constructing Duration Neutral Portfolios to Benefit from Change in Curvature

Long barbell and a short bullet

 Benefit from flattening yield curve

 Benefit from increase in curvature

 More valuable when interest rate volatility is high

Short barbell and a long bullet

 Benefit from steepening yield curve

 Benefit from decrease in curvature

 More valuable when interest rates are stable

Condor: 4 positions Examples:

Framework for Evaluating Yield Curve Trades

+ Rolldown return + E(Change in price based on investor’s views of yields and spreads)

- E(Credit losses) + E(Currency gains or losses)

If forecasted ending yield < forward rate  expected return > one-period rate

If forecasted ending yield > forward rate  expected return < one-period rate

Expected gain/loss from change in yield ≈ [-MD × ∆Yield] + [½ × Convexity × (∆Yield)2]