FI Question

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BaseballRedhawks

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Hi All,
Lets bust our asses these ;ast few months before the exam.
I have one quesiton below, that I was hoping someone could explain how they analyze and go through it.
Thanks!
A portfolio manager anticipates a major increase in market interest rates. Which trading strategy would be most likely to generate above average returns in a bond investment? Purchasing:
1) Short maturity bonds with high coupon rates
2) bonds that will increase the average duration of the investment portfolio.
3) long maturity bonds with low coupon rates.
 
If interest rates rise, he wants to shorten his duration, so that the decline in price is low:
%ΔP = -Dmod × Δy
Duration is lower for:
  • Shorter maturity
  • Higher coupon
  • Higher YTM
At the same time, he would prefer high coupons, to increase his cash flow. Both point to answer 1).
 
Also, so i understand that longer maturity = higher duration. Everything else like coupon and yield are inverse. Is this the root to the answer? Just looking at it the opposite way?
Thanks!
 
Also, so i understand that longer maturity = higher duration. Everything else like coupon and yield are inverse. Is this the root to the answer? Just looking at it the opposite way?
Thanks!
 
BaseballRedhawks wrote:Also, so i understand that longer maturity = higher duration. Everything else like coupon and yield are inverse. Is this the root to the answer? Just looking at it the opposite way?
Click to expand...
Yes: longer maturity leads to longer duration, but higher coupon and higher YTM lead to lower duration (for normal bonds, all else equal).
BaseballRedhawks wrote:Thanks!
Click to expand...
You’re welcome.
 
Yes ans is A. Because the price volatility of non-callable bonds is inversely related to the level of market yields. As yields increase, bond prices fall, and the price curve gets flatter. Bond price sensitivity is lowest when yields are high. Longer maturity bonds with lower coupon rates are more sensitive to interest rate risk and their price will decrease more than short term, high coupon rate bonds.
 
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