4.3 Modeling Non-Parallel Term Structure Shift and Hedging
Question 1
The main problem associated with using single-factor approaches to hedge interest rate risk
A. No method can hedge interest rate risk.
B. Single-factor models assume mean-reversion between one short-term and one long-term rate.
C. Single-factor models assume effects across the entire curve dictated by one rate.
D. Single-factor models assume risk-free securities have credit exposure.
Answer: C
Single-factor models assume that any change in any rate across the maturity spectrum can indicate changes across the maturity spectrum can indicate changes across any other portion of the curve.
Question 2
PE2018Q92 / PE2019Q92 / PE2020Q92 / PE2021Q92
You are using key rate shifts to analyze the effect of yield changes on bond prices. Suppose the 10-year yield has increased by
10
10
10 basis points and this shock decreases linearly to zero for the 20-year yield. What is the effect of this shock on the 14-year yield?
A. Increase of
0
0
0 basis points
B. Increase of
4
4
4 basis points
C. Increase of
6
6
6 basis points
D. Increase of
10
10
10 basis points
Answer: C
Learning Objective: Describe key-rate shift analysis.
The 10 10 10 basis point shock to the 10-year yield is supposed to decline linearly to zero for the 20-year yield. Thus, the stock decrease by 1 1 1 basis point per year and will result in an increase of 6 basis points for the 14-year yield.
Question 3
Using key rates of 2-year, 5-year, 7-year, and 20-year exposures assumes all of the following except that the:
A. 2-year rate will affect the 5-year rate
B. 7-year rate will affect the 20-year rate
C. 5-year rate will affect the 7-year rate
D. 2-year rate will affect the 20-year rate
Answer: D
Key rate exposures assume that key rates chosen adjacent to the rate of interest are affected, not across other key rates.
Question 4
PE2018Q90 / PE2019Q90 / PE2020Q90 / PE2021Q90
A fixed-income consultant is preparing a presentation advising corporate clients on the use of key rate 01’s and forward-bucket
01
01
01’s to monitor and hedge their interest rate exposures. Which of the following statements would be correct to include in the presentation?
A. The sum of all key rate '
01
01
01s is equal to the change in price from shifting the yield to maturity by one basis point.
B. The key rate shift of the 10-year par rate leads to higher spot rates for all maturities.
C. The sum of all forward bucket '
01
01
01 shifts is equal to shifting the entire forward curve by one basis point.
D. By choosing the key rates for the US Treasury as 2-, 5-, 10-, and 30-year par yields, a 15-year on-the-run US Treasury bond has no exposure to the 30-year key rate shift.
Answer: C
Learning Objective: Define key rate exposures and know the characteristics of key rate exposure factors, including partial ‘
01
01
01s and forward-bucket ‘
01
01
01s.
C is correct. This is the basic definition of forward bucket ' 01 01 01s.
A is incorrect. The sum of key rate ' 01 01 01s is equal to a parallel shift in the par curve, not in the flat yield to maturity.
B is incorrect. Par curve effects are not spot curve effects.
D is incorrect. The 30-year key rate shifts rates between 10 and 30 years, and thus has an effect on the cash flows of a 15-year coupon bond.
Question 5
An investment in a callable bond can be analytically decomposed into a:
A. Long position in a non-callable bond and a short position in a put option
B. Short position in a non-callable bond and a long position in a call option
C. Long position in a non-callable bond and a long position in a call option
D. Long position in a non-callable bond and a short position in a call option
Answer: D
A callable bond includes an embedded option for the issuer to call the bond at a stated redemption or call price. If the issuer is long the call option, then the holder of a callable bond is short the call option.
Question 6
Which of the following statements about a puttable bond and a callable bond is correct?
A. The put option of a puttable bond is more expensive than the call option of the callable bond.
B. A puttable bond will have a lower yield than a comparable callable bond.
C. The value of a callable bond increases when interest rate volatility increases.
D. Long position in a puttable bond has more interest rate risk than a long position in a callable bond.
Answer: B
Callable bond can be decomposed into a long position in a straight bond minus a call option on the bond price. Puttable bond can be decomposed into a long position in a straight bond plus a put option on bond price.
Question 7
Consider a convertible bond that is trading at a conversion premium of 20 20 20 percent. If the value of the underlying stock rises by 25 25 25 percent, the value of the bond will:
A. Rise by less than
25
%
25\%
25%
B. Rise by
25
%
25\%
25%
C. Rise by more than
25
%
25\%
25%
D. Remain unchanged
Answer: A
The convertible bond implicitly gives bondholders a call option on the underlying stock. The delta of this option will vary between
0
0
0 (when the option is extremely out of the money) and
1
1
1 (when the option is extremely in the money). In this case, the bond is trading at a conversion premium of
20
%
20\%
20% so the delta must be somewhere between zero and one, and hence the price of the convertible bond will rise by less than the price of the underlying stock.
Question 8
Bonds issued by the XYZ Corp. are currently callable at par value and trade close to par. The bonds mature in 8 years and have a coupon of 8%. The yield on the XYZ bonds is 175 basis points over 8-year US Treasury securities, and the Treasury spot yield curve has a normal, rising shape. If the yield on bonds comparable to the XYZ bond decreases sharply, the XYZ bonds will most likely exhibit:
A. Negative convexity
B. Increasing modified duration
C. Increasing effective duration
D. Positive convexity
Answer: A
As yields in the market declines, the probability that the call option will get exercised increases. This causes the price to reduce relative to an otherwise comparable option free bond, which is also known as a negative convexity.
Question 9
Which of the foliowing statements are TRUE?
I. The convexity of a 10-year zero coupon bond is higher than the convexity of a 10-year, 6% bond.
II. The convexity of a 10-year zero coupon bond is higher than the convexity of a 6% bond with a duration of 10 years.
III. Convexity grows proportionately with the maturity of the bond.
IV. Convexity is always positive for all types of bonds.
V. Convexity is always positive for “straight” bonds.
A. I only
B. I and II only
C. I and V only
D. II, III, and V only
Answer: C
All else equal, convexity increase for longer maturities, lower coupons, and lower yields.
Bonds with embedded option (e.g., callable bonds) exhibit negative convexity over certain ranges of yields while straight bonds with no embedded options exhibit positive convexity over the entire range of yields.
Question 10
PE2022Q87
The CRO of a small bank is estimating the volatility of the bank’s asset portfolio using its key rate
01
01
01s, in preparation for calculating the bank’s market risk capital. The portfolio is only exposed to 2-year and 10-year spot rates. Relevant information on market rates and the portfolio is as follows:
2-year | 10-year | |
---|---|---|
Standard deviation of daily changes in the spot rate (in bps) | 4 4 4 | 11 11 11 |
Correlation between spot rate | 0.6 0.6 0.6 | 0.6 0.6 0.6 |
Portfolio key rate 01 01 01s (CAD) | 52 52 52 | 97 97 97 |
Given the above information, what is the standard deviation of the daily change in portfolio value?
A. CAD
516
516
516
B. CAD
988
988
988
C. CAD
1
,
026
1,026
1,026
D. CAD
1
,
203
1,203
1,203
Answer: D
Learning Objective: Apply key rate and multi-factor analysis to estimating portfolio volatility.
D is correct. The equation for the variance of the change in portfolio value is:
σ p 2 = ∑ i = 1 n ∑ j = 1 n ρ i , j σ i σ j × KR 0 1 i × KR 0 1 j = \sigma_p^2=\sum^n_{i=1}\sum^n_{j=1}\rho_{i,j}\sigma_i\sigma_j \times \text{KR}01_i\times \text{KR}01_j= σp2=∑i=1n∑j=1nρi,jσiσj×KR01i×KR01j=
σ 2 Y 2 KR 0 1 2 Y 2 + σ 10 Y 2 KR 0 1 10 Y 2 + 2 ρ 2 Y , 10 Y σ 2 Y σ 10 Y KR 0 1 2 Y KR 0 1 10 Y = 1448076 \sigma_{2Y}^2\text{KR}01_{2Y}^2+\sigma_{10Y}^2 \text{KR}01_{10Y}^2+2\rho_{2Y,10Y} \sigma_{2Y} \sigma_{10Y}\text{KR}01_{2Y} \text{KR}01_{10Y}=1448076 σ2Y2KR012Y2+σ10Y2KR0110Y2+2ρ2Y,10Yσ2Yσ10YKR012YKR0110Y=1448076
The standard deviation is therefore: 1448076 = 1203.06 \sqrt{1448076}=1203.06 1448076=1203.06