M2: The Use and Abuse of Conventional Analytics · 2016-06-24 · Module 2: The Use and Abuse of...

Principles of Performance |

The Use and Abuse of

Conventional Analytics

Nigel Johnson

Director of Performance Trust University®

Module 2

Chicago, IL | June 27, 2016

Purpose

To critique the cornerstones of conventional analytics.

Module 2: The Use and Abuse of Conventional Analytics© 2016 Performance Trust. All Rights Reserved. 3

In This Module

Current Practice in Fixed-Income Investing

Conventional Analysis: Risk and Reward

Yield – A Good Measure of Reward?

Yield – What is it Really?

Duration – A Good Measure of Risk?


In This Module







The Status Quo

I, like my peers, came from the loan or accounting side

of the institution. Most of us inherited oversight of the

investment function and have never had any real formal

training in fixed-income analytics.

A Portfolio Manager


The Status Quo

I, like my peers, was taught how to sell a bond.

We figured that portfolio managers knew what they

needed. As long as we stuck to high credit quality all

we needed to figure out was, “What will he/she buy?”

A Broker


The Status Quo: Wall Street vs. Main Street

I, like my peers, was taught how to…

Economist

An Investigation of Top-Down Investing…


Definition

Top-Down Investing

An investment approach that involves first looking

at the “Big Picture” in the economy, then choosing

to invest or not to invest in securities that will

out-perform given the “Big Picture.”


Every six months, over 50 economists predict interest rates

a year from now for a column in The Wall Street Journal.

How many even come close?

Economic Predictions


Economist Predictions 1 Year in Advance

What percentage of the economists came within 30 bps?

1

2

3

4

5

6

Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013 Dec 2014 Dec 2015

WITHIN 30 BPS 2%8%6%0%10% 0% 24% 0%8%

Source: Wall Street Journal


1

2

3

4

5

6

Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013 Dec 2014 Dec 2015

WITHIN 50 BPS

Economist Predictions 1 Year in Advance

What about 50 bps?

13%17%15%0%33% 0% 35% 0%22%

Source: Wall Street Journal


Economists’ Predictions

An economic forecaster is like a cross-eyed javelin

thrower; they do not win many accuracy contests,

but they keep the crowd’s attention.

ANONYMOUS


In a recent survey, Jim Bianco studied 20 years of

The Wall Street Journal interest rate surveys and

found that as a group, they successfully predicted the

future direction of interest rates only 30% of the time.

The problem with “top-down investing”

If the forecast is wrong, the investment will be wrong.

And would you know which security to buy even if your

forecast was correct?

Top-Down Investing


Peter Lynch’s Stock Market Wisdom Applies

to All Investments

Nobody can predict interest rates, the future

direction of the economy, or the stock market.

Dismiss all such forecasts and concentrate on

what’s actually happening to your investments.

If you don’t study your investments you have

the same chance of success as you do in a poker

game if you bet without looking at your cards.

PETER LYNCHPARAPHRASED FROM

BEATING THE STREET


Key Takeaway

Seeking fixed-income outperformance

is not about guessing future interest rates.


In This Module







Back to the Sandlot/Lobby

Fundamentals of CDs

Rate Yield

2 Numbers:

What are they?

&


Coupons reinvested at

_____%

For Bonds, Yield is Not What You Get

CD RateInterest Payments

Compounded at the Rate

CD Yield

??????

I Don’t Know!

Yield on a CD

Yield on a Bond

Bond Yield


Note: Bond yields are reported on a semi-annual compounding basis

Cash Flow DescriptionCash

Flow

Accumulated

Cash Flow

Initial Investment -100 ???

1st Coupon (6 Months) 3.50 3.500 The first coupon

2nd Coupon (6 Months) 3.50 ??? Interest on interest? At what reinvestment rate?

3rd Coupon (6 Months) 3.50 ???

4th Coupon (6 Months) 3.50 ???

Return of Principal 100 ???

An Illustration

2-Yr Treasury: 7% Coupon, 7% Yield (Price = 100, or “Par”)

Dollars Today

Present Value

Coupon Interest

plus

Interest on Interest

Dollars Tomorrow

Future Value


Let’s assume a 7% reinvestment rate for all cash flows

Cash Flow DescriptionCash

Flow

Accumulated

Cash Flow

Initial Investment -100

1st Coupon (6 Months) 3.50 3.500 Coupon is only cash flow

2nd Coupon (6 Months) 3.50 7.123 New coupon plus 3.50 x (1 + reinvestment rate)

3rd Coupon (6 Months) 3.50 10.872 New coupon plus 7.123 x (1 + reinvestment rate)

4th Coupon (6 Months) 3.50 14.752 New coupon plus 10.872 x (1 + reinvestment rate)

Return of Principal 100 114.752 Total Ending Dollars

An Illustration

2-Yr Treasury: 7% Coupon, 7% Yield (Price = 100, or “Par”)

Dollars Today

Present Value

Coupon Interest

plus

Interest on Interest

Dollars Tomorrow

Future Value


When different reinvestment rates are used, we arrive at different

effective compounded yields.

In fact, this result is also known as Total Rate of Return (Total Return).

Yield on a bond is not like yield on a CD because the compounding rate

is unknown. Yield is NOT “what you get” on a bond.

What if a Different Reinvestment Rate is Used?

Beginning

Dollars

Reinvestment

Rate

Ending

Dollars

Effective,

Compounded Yield

$1,000,000.00 7.00% $1,147,523 7.00%

$1,000,000.00 3.00% $1,143,182 6.80%

$1,000,000.00 10.00% $1,150,854 7.15%

As we will see, Total Return is the true measure

of “what you get” on a bond.


Implication

5-Yr Treasury and 5-Yr Corp with a +100 Spread ($1 Million Face)

Compare Two Similar Bonds

UST Corporate Bond

Year 1 6.50 7.50

Year 2 6.50 7.50

Year 3 6.50 7.50

Year 4 6.50 7.50

Year 5 6.50 7.50

Compounded

Income (Implied)$376,894 $445,044

If yield is not “what you get” on a bond then spread, or additional yield

of one bond over another, is not what you additionally get on a bond.

The implied spread differential in income between these two bonds

is $68,150. But are we treating these bonds consistently?


Are We Being Consistent?

In the real world, portfolio managers reinvest their cash flows at

consistent reinvestment rates, regardless of their sources.

We are not, because we are using inconsistent reinvestment rates

to arrive at those results (not a level playing field).

6.5% US Treasury 7.50% Corporate Bond

Reinvestment

Rate$$ Return $$ Return

Difference

in Dollars

Difference

in Returns

6.50% $376,894 6.50%

7.50% $445,044 7.50%


Where is the 100 bps Spread?

Holding reinvestment rate constant results in less than 100 bps

difference in return, and less than the $68,150.


Reinvestment


Difference

in Dollars

Difference

in Returns

6.50% $376,894 6.50% $434,614 7.35%

7.50% $385,440 6.63% $445,044 7.50%


Not only is yield not “what you get,”

but spread is not the difference in what you get.

Where is the 100 bps Spread?

In fact, no matter where we set the consistent reinvestment rate,

the 100 bps actual realized spread is elusive.


Reinvestment


Difference

in Dollars

Difference

in Returns

3.50% $351,602 6.12% $405,723 6.93% $54,121 0.81%

4.50% $359,727 6.24% $415,098 7.07% $55,371 0.83%

5.50% $368,071 6.37% $424,726 7.21% $56,655 0.84%

6.50% $376,894 6.50% $434,614 7.35% $57,974 0.85%

7.50% $385,440 6.63% $445,044 7.50% $59,327 0.87%

8.50% $394,476 6.77% $455,193 7.65% $60,717 0.88%

9.50% $403,754 6.90% $465,899 7.80% $62,145 0.90%


The Truth About Mortgage-Backed “Yields”

We have been on the record for a very long time of the same phenomenon in

the mortgage-backed security world for 20 years. In fact, our CEO, Rich Berg,

co-authored the article on below in 1994.

How come I have all these high yields in my portfolio,

but I’m not making the money?


Reinvestment

Rate

Realized

Yieldvs Quoted

Realized

Yieldvs Quoted

Realized

Spread

“Realized Yield and Spread”

Benchmark

5-Yr Treasury

5.27% Purchase Yield

6.31% 5.38% +0.11 6.31% 0 0.93

5.27% 5.27% 0 5.93% -0.38 0.66

4.50% 5.19% -0.08 5.66% -0.65 0.47

3.00% 5.03% -0.24 5.13% -1.18 0.10

MBS Alternative

15-Yr MBS

6.31% Purchase Yield

MBS Spread

104 bps

Not only is yield not “what you get,”

but spread is not the difference in what you get.


Impact of Reinvestment Rate Over a Longer Horizon

Assuming an average reinvestment rate of 7% from 1981 – 1991

the 10-yr return was 10.88% and total net dollars was

$1,884,840.79 or $749,610 less than “expected.”

2-Yr 3-Yr 5-Yr 10-Yr

Yield (%) 13.97 13.67 13.46 13.33

Duration 1.69 2.40 3.56 5.41

Feb 15

1981


The disconnect between yields and “what you get” is even more obvious

when you consider negative yield cases. Consider this CMO:

A Note on Negative Yields and Reinvestment Rates

In order for the negative yield to be “what you get” you would

have to reinvest the cash flows at negative rates.


Here is a “What You Get” (Total Return) Calculator

It is asking for a reinvestment rate. We know we would not reinvest cash flows

at -3.799%, the only way that could be the Total Return.


“Worst Case” Reinvestment

Assuming we didn’t reinvest at all, the Total Return would be 214 bps higher

than the reported yield. In Module 6, we will see other shortfalls of the yield

table approach to analyzing mortgages.


In the bond world,

yield is not what

you actually get.

Reprinted from the ABA Banking Journal

We have been educating

investors on this

topic for decades!


In This Module







Definition

What is a bond?

A certificate of debt issued by a government, agency

or corporation guaranteeing payment of the original

principal plus interest by a specified future date.


A Bond is a Series of Cash Flows

3-Yr Bond, 2.00% Coupon

Period 16-Mo

Period 212-Mo

Period 318-Mo

Period 424-Mo

Period 530-Mo

Period 6*36-Mo

*Chart is illustrative. It is not to scale.

1%

$10,000

1%

$10,000

1%

$10,000

1%

$10,000

1%

$10,000

100 + 1%

$1,010,000


FV = PV (1 + i)n

The Time Value of Money

Where:

PV = Present Value

i = Discount Rate Per Period

n = Number of Periods

FV = Future Value

EXAMPLE

1 Period 2 Periods

FV = 100 (1 + 7%)1 FV = 100 (1 + 7%)2

107 = 100 (1 + 0.07)1 114.5 = 100 (1 + 0.07)2


Future Value

In 1626, Peter Minuit

bought Manhattan Island

from the Canarsee tribe

for an alleged fee of $24

in goods.


22.96 Square Miles

Population of 1.6 Million

Population Density of 70,595 per square mile

Per Capita Income of over $100,000

Only 12% of Voters registered Republican

Last time the island voted Republican…

Manhattan Island Interesting Facts

1920


New York was originally called New Amsterdam

The Vaults 80 feet beneath the Federal Reserve Bank

on Wall Street store 25% of the World’s bullion

The Dutch traded New Amsterdam (New York) to the British

in exchange for the tiny Indonesian island of Pulau Run



New York was originally called New Amsterdam

The Vaults 80 feet beneath the Federal Reserve Bank

on Wall Street store 25% of the World’s bullion

The Dutch traded New Amsterdam (New York) to the British

in exchange for the tiny Indonesian island of Pulau Run


Estimated Value:

$8 Trillion



Did the Canarsee Tribe

make a good or bad deal?


3 Billion Dollars

FV = $24 x (1 + i)n

FV = $24 x (1.05)383


$24 Compounded for 383 Years

@ 5% would be $3 Billion

@ 6% would be $118 Billion

@ 7% would be $18 Trillion

@ 8% would be $152 Trillion

Compound interest is the most

powerful force in the Universe.

ALBERT EINSTEIN(MAYBE)


According to many historians, the Indians who sold the island did not

even live on the island.

The Canarsee tribe lived on Long Island, the Weckquaesgeek tribe

lived on Manhattan and were never consulted on the trade.

The Indians did not believe that anyone could own the land.

It Gets Better…


Where:

PV = Present Value

i = Discount Rate per period

n = Number of periods

FV = Future Value

The Time Value of Money

Price is the present value of the future cash flows

NOTE:

Since bond calculations conventionally use 2 periods per year,

i = yield / 2

PV = FV / (1 + i)n

FV = PV × (1 + i)n


Definitions

Price

The sum of the present value of future cash flows,

given a yield (discount rate).

Yield

The discount rate which, when used to present value

the future cash flows, results in the sum of those

present valued cash flows being equal to the price.


Price and Yield

For bonds whose cash flows don’t change when

interest rates change (bullets), once the yield is

given, the price can be solved for.

Conversely, if the price is given, the yield can

be solved for.

In a real sense, yield is price and price is yield.

PRICE = CF1

+CF2

+…+CFn

( 1 + y/2)1 (1 + y/2)2 (1 + y/2)n


What is Price?

PRICE =1.5

+1.5

+1.5

+101.5

(1 + 0.01)1 (1 + 0.01)2 (1 + 0.01)3 (1 + 0.01)4

PRICE =1.5

+1.5

+1.5

+101.5

(1 + 0.015)1 (1 + 0.015)2 (1 + 0.015)3 (1 + 0.015)4

For example, consider a 2-Yr Bond, 3% Coupon,

3% Yield that pays semi-annually.

Price = $100.00

Price = $101.95

For the same cash flows, a 2% yield has the following price:


99 =1

+1

+1

+1

+1

+101

(1 + y/2)1 (1 + y/2)2 (1 + y/2)3 (1 + y/2)4 (1 + y/2)5 (1 + y/2)6

Let’s try 3.00% yield

Price = $97.15, which is less than the actual price of $99

so we must try a lower yield.


Price = $98.56, price still too low.


Price = $99.00, which equals the price, thus the yield is 2.35%.

What is Yield?

3-Yr Bond, 2% Coupon, $100 Face, $99.00 Price, Yield = ?

(remember, the periodic discount rate is ½ the annual yield)


9

Calculate Price

Module 2 Exercises

PRICE = CF1

+CF2

+…+CFn

( 1 + y/2)1 (1 + y/2)2 (1 + y/2)n

CF = Cash Flow

Y = Bond-Equivalent Yield

N = Number of Periods

Price is the sum of the present values

of future cash flow

For the following five bond exercises,

assume a principal of $1


TOTAL PV PRINCIPAL PRICE

$ / $ × 100 = $971,511

PRESENT

VALUE + + + + + =$9,852 $9,706 $9,563 $9,421 $9,282 $923,687

Calculate the Price of a 3-Yr BondExercise 2.1

10

3-Yr Bond, 2.00% Coupon, 3% Yield

INTEREST PAYMENT COUPON INTEREST PAYMENT

INTEREST PAYMENT = × ( ÷ 2 ) =

PRESENT VALUE OF

AN INTEREST PAYMENT

INTEREST PAYMENT YIELD ÷ 2

÷ ( 1 + )n

$1,000,000 0.02 $10,000

$10,000 0.015

INTEREST

PAYMENT

PERIOD 1 PERIOD 2 PERIOD 3 PERIOD 4 PERIOD 5 PERIOD 6

6-Mo 12-Mo 18-Mo 24-Mo 30-Mo 36-Mo

1 MM 97.15

$10,000 $10,000 $10,000 $10,000 $10,000

$1,010,000

PRINCIPAL +

INTEREST

NOTE: Chart is illustrative and is not to scale.

/1.093443


Calculate Using a Higher YieldExercise 2.2

11


PRESENT VALUE OF

AN INTEREST PAYMENT $10,000 ÷ ( 1 + )n0.025

INTEREST

PAYMENT$10,000 $10,000 $10,000 $10,000 $10,000

$1,010,000


TOTAL PV PRICE

$ $917,378

PRESENT

VALUE + + + + + =$9,756 $9,518 $9,285 $9,059 $8,838 $870,922


6-Mo 12-Mo 18-Mo 24-Mo 30-Mo 36-Mo

91.73


Calculate Using a Lower YieldExercise 2.3

12


INTEREST

PAYMENT


6-Mo 12-Mo 18-Mo 24-Mo 30-Mo 36-Mo

$10,000 $10,000 $10,000 $10,000 $10,000

$1,010,000

PRESENT VALUE OF

AN INTEREST PAYMENT $10,000 ÷ ( 1 + )n0.005

TOTAL PV PRICE

$ $1,029,479

PRESENT

VALUE + + + + + =$9,950 $9,900 $9,851 $9,802 $9,753 $980,223

102.94



Let’s Summarize What We’ve Done So Far

3-Yr Bond, 2% Coupon

Yield Price

0%

1% $102.95

2%

3% $97.15

4%

5% $91.74

6%

7%

8%

9%

10%


Other Yields Produce Other Prices


Yield Price

0% $106.00

1% $102.95

2% $100.00

3% $97.15

4% $94.40

5% $91.74

6% $89.17

7% $86.68

8% $84.27

9% $81.95

10% $79.70

For bonds whose cash flows don’t

change with changes in interest

rates, there is only one price for

each yield. Likewise, there is only

one yield for each price. Or to put it

another way, there is only one price

yield relationship since there is only

possible cash flow.


$65

$70

$75

$80

$85

$90

$95

$100

$105

$110

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

Let’s Graph the Relationship Between Yield and Price


When rates go up, the price goes down

(the yield term is in the denominator).

PR

ICE

YIELD


$65

$70

$75

$80

$85

$90

$95

$100

$105

$110

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

The Price – Yield Line is Not Straight


PR

ICE

YIELD

1%

3%

5%Price Change

$5.80

Price Change

$5.41

Because there are exponents in the denominator, this line is curved. This means that

the change in price for an equal but opposite change in yield is not the same amount.


Calculate the Price of a 2-Yr BondExercise 2.4

13


TOTAL PV PRICE

$ $1,019,039

PRESENT

VALUE + + +$24,509 $24,029 $23,558 $946,943

INTEREST PAYMENT = × ( ÷ 2 )

PRESENT VALUE OF

AN INTEREST PAYMENT ÷ ( 1 + )n

$1,000,000 0.05

$25,000 0.02

INTEREST

PAYMENT

PERIOD 1 PERIOD 2 PERIOD 3 PERIOD 4

6-Mo 12-Mo 18-Mo 24-Mo

$25,000 $25,000 $25,000

$1,025,000

101.90



Definition

Spread

The difference between two yields – commonly

between the yield on the instrument in question and

some benchmark rate (such as the similar maturity

U.S. Treasury rate).


Components of Spread?

3-YEAR

YIE

LD

Benchmark Treasury

(No Liquidity, Credit,

or Option Risk)

Interest Rate Risk

(Includes Current and

Future Inflation Expectations,

Future Monetary Policy, etc.)

Liquidity Risk

Spread

Yield

Option Risk

Credit Risk


The 3-Yr Treasury on Nov. 6, 2011 is yielding 0.46%

FNMA 2.69 Coupon, Nov. 6, 2014 maturing,

is offered at a spread of +29 bps over the 3-Yrs

So at yield of 0.46 + 0.29, or 0.75

This is the appropriate way to use spread

(as a mechanism for specifying a price)

Spread is Used as a Shorthand When Discussing Prices

But how is spread often (erroneously)

applied to investment thinking?


PRESENT

VALUE

Treasury Rate + Spread = Agency YieldExercise 2.5

14

3-Yr FNMA, 2.69% Coupon, Yield

$13,399 $13,349 $13,250 $13,200 $990,944$13,299

$1,013,450

YIELD

+ =

PRESENT VALUE OF

AN INTEREST PAYMENT ÷ ( 1 + )n

0.75%

$13,450 0.00375

TOTAL PV PRICE

$ $1,057,441


6-Mo 12-Mo 18-Mo 24-Mo 30-Mo 36-Mo

105.74

$13,450 $13,450 $13,450 $13,450 $13,450

0.46% 0.29%



Quiz

A. The annual percentage return that is earned on a security, as

computed in accordance with standard industry practices

B. The discount rate used so that the present value of future defined

cashflows equals the price

C. Book income received from a security

Yield on a Bond is…

WRONG!

WRONG!

B. The discount rate used so that the present value of future defined

cash flows equals the price


In This Module







Definition

Duration sounds like a measure of what?

Macaulay’s Duration Defined

The weighted average maturity of a bond’s cash

flows, where the present values of the cash flows

serve as the weights. The greater the duration of

the bond, the greater its percentage price volatility.

What is it used for?


1*PVCF1 + 2*PVCF2 + 3*PVCF + … + n*PVCFn

K*Price

1938 Macaulay Duration

Where:

K = Number of periods per year

n = Number of years to maturity multiplied by K

PVCFPD = Present value of cash flows

in period PD

NOTE: Graphic is illustrative. It is not to scale. Period 1 2 3 4 5

PV of Time

Weighted Interest*

PV of Time

Weighted Principal*


Example: 5-Yr Treasury 6% Coupon at a 6% Yield

PeriodCash

Flow

Present

Value

Period ×

Present Value

1 3 2.913 2.913

2 3 2.828 5.656

3 3 2.745 8.236

4 3 2.665 10.662

5 3 2.588 12.939

6 3 2.512 15.075

7 3 2.439 17.075

8 3 2.368 18.946

9 3 2.299 20.693

10 103 76.642 766.417

878.611

Price 100.000 [878.6 / (2×100)]

Duration 4.393


How Does Price Change as Yield Changes?

Note that as yield goes up, the price goes down and as

yield goes down the price goes up. We saw previously that

these price changes for equal but opposite yield changes

are not the same.

It would be nice to have a formula to quantify this rate

of change of price as yield changes. It turns out, a slight

tweak to the Macaulay Duration formula gives this rate

of change of price formula results in a formula, called

Modified Duration, that does this correctly.

PRICE = CF1

+CF2

+…+CFn

( 1 + y/2)1 (1 + y/2)2 (1 + y/2)n


Where:


Modified Duration =Macaulay Duration

(1+ yield / K)


Definition

Modified Duration

The percentage price change of a security for a given

change in yield. The higher the modified duration of a

security, the higher its risk.

Therefore,

If I had a duration of 1.00 and rates moved

100 bps I would expect a 1% price change.


Modified Duration Examples

5-Yr Treasury 6.00% Coupon (semi-annual coupon) at a 6.00% Yield

Macaulay Duration = 4.393

Modified Duration = 4.393 / 1.03

Modified Duration = 4.265


What Does Duration Tell Us?

I am considering purchasing one of 3 bonds on 5/1/2013:

“Hey…I need some advice!”

Option AOR

Option BOR

Option C

Yield 0.82% 1.15% 1.26%

w/Modified Duration 4.66 0.99 3.78

What does the modified duration suggest the price

will do if interest rates rise by 100 bps?


In Fact, We Did Experience a Rate Rise

3 Month Period ~7 &10 years Rates up 100 bps, 5 years up 84 bps, 1 year Unchanged


Bond A: 5-Yr Bullet Went from $100.31 to $96.473

Modified Duration: 4.66

Expected Change = 0.84 × 4.66 = 3.91%

Actual Price Decline: 3.83%

What Actually Happened to the Prices?

Bond B: 5-Yr NC1 Went from $100 to $97.15


Expected Change = 0 × 0.99 = 0



Bond C:15 Year 2.5% PoolWent from $104.59 to $99.34


Expected Change = 0.50 × 3.78 = 1.88%


Modified Duration —

Not a Great Predictor for MBS, Either


In general Duration measures the price sensitivity

of a bond to a small change in interest rates.

For securities such as MBS, Duration measures such

as “Modified Duration” and another well known formula

“Macaulay Duration” have little meaning when it comes

to interest risk management. The formulas are limited

since they assume cash flows do not change if

interest rates change. In this case these formulas

are inappropriate.IVAN BANDIC, MANAGING DIRECTOR RBC CAPITAL MARKETS



K*Price

Problem With Duration

Where:




in period PD

NOTE: Graphic is illustrative. It is not to scale. Period 1 2 3 4 5

What if cash flows change when interest rates change?

2.70

PV of Time

Weighted Interest*

PV of Time

Weighted Principal*


Problem With Duration

PV of Time

Weighted Interest*

PV of Time

Weighted Principal*

Where:




in period PD

NOTE: Graphic is illustrative. It is not to scale. Period 1 2 3 4 52.70

What if cash flows change when interest rates change?


K*Price


What is the Duration of a 10-Yr NC 1 Agency?

FHLB 3.05 Sep 9, 2020


What is the Duration of a 10-year NC 1 Agency?


Duration =V- - V+

2 Vo (∆y)

Effective Duration

Used for Bonds with Embedded Options

Where:

∆ y = Change in the yield of the bond (in decimal form)

V- = Estimated value of the bond per $100 of par value

if the yield is decreased by ∆y

V+ = Estimated value of the bond per $100 of par value

if the yield is increased by ∆y

Vo = Initial price of the bond (per $100 of the par value)

We will see that calculating scenario returns

is a better way to see the effect of duration.


Words of Wisdom from a Master Investor

Academics, however, like to define investment ‘risk’

(differently) … In their hunger for a single statistic to

measure risk … they forget a fundamental principle:

It is better to be approximately right than

precisely wrong.

WARREN BUFFETTAMERICAN BUSINESS MAGNATE,

INVESTOR and PHILANTHROPIST


Duration, like average life, is a tool that measures the “risk” of a bond.

Duration runs into problems when it comes to securities with options,

changing cash flows, or large rate changes.

Duration makes no attempt to measure reward or return.

What is better…

Duration

a 5-Yr or a 1-Yr?

Summary

Following conventional analytics is not in the portfolio manager’s best interest.

Yield is a pricing mechanism and “not what you get.”

© 2016 Performance Trust Capital Partners, LLC (which, along with its affiliates, is referred to

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M2: The Use and Abuse of Conventional Analytics · 2016-06-24 · Module 2: The Use and Abuse of...

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Transcript of M2: The Use and Abuse of Conventional Analytics · 2016-06-24 · Module 2: The Use and Abuse of...