Week 4

Week 4 - Assignment: Assess Bond Pricing and Analysis to Build a Portfolio

Instructions

Examine some important theories and concepts associated with interest rates. Safe investments usually have fixed interest rates. You have been asked to assemble this presentation for a weekly staff meeting, so your audience will be senior managers and a couple of vice presidents. Note their interest in this topic is very high so you need to be very succinct and clearly explain the risks and rewards of building a successful portfolio. In reference to term structure, interest rate risks, and duration supported by numerical illustration where applicable, in a PowerPoint presentation, evaluate the following:

1. The pricing of bonds, the calculation of the bond yield, and how bond prices adjust across time for premium, par, and discount bonds.

2. An evaluation of the yield curve and the theories to explain the shape. Discuss how these theories can be helpful in bond investing.

3. The interest rate risk for bond investments. Form a graphical presentation of the concepts.

4. The concept of duration and how it is useful in the context of bond portfolio analysis. You want to clearly discuss both the price risk measurement value for duration as well as how duration can measure the dynamics of price and re-investment rate risk across time for a bond portfolio.

It is critical that with each discussion above that examples are formed to illustrate the concept. Whenever possible, you want to demonstrate concepts using graphical approaches.

The required length of the PowerPoint Presentation option for this assignment is 12-15 slides (with a separate reference slide). Your presentation MUST include notes that contain 100-150 words per slide (this is your script). Be sure to include citations for quotations and paraphrases with references in APA format and style. Save the file as a PPT file with the correct course code information in the name.

Bond Investments

According to Bodie, Kane, and Marcus (2014), to effectively understand bond analysis, we want to first review some of the meaningful interest rate theories. The first is the term structure of interest rates, or in a less formal development - the yield curve (although the actual metrics used between the two are different). The yield curve maps the maturities on bonds or fixed income securities to the associated interest rate of yield. The most common shape of the yield curve will be upward sloping. The shape of the yield curve is explained by several optional theories with the best known being the Expectations Theory. The Expectations Theory explains the shape as a function of future expected interest rate movements. This is useful for bond investors as the yield curve reveals then the markets expectations for the direction of interest rate changes in the future.

Even default-free bonds such as Treasury issues are subject to interest rate risk. Longer-term bonds generally are more sensitive to interest rate shifts than are short-term bonds. A measure of the average life of a bond is Macaulay's duration, defined as the weighted average of the times until each payment made by the security, with weights proportional to the present value of the payment. Duration is a direct measure of the sensitivity of a bond's price to a change in its yield. The proportional change in a bond's price equals the negative of duration multiplied by the proportional change in 1 + y.

Convexity refers to the curvature of a bond's price-yield relationship. Accounting for convexity can substantially improve on the accuracy of the duration approximation for the response of bond prices to changes in yields. Immunization strategies are characteristic of passive fixed-income portfolio management. Such strategies attempt to render the individual or firm immune from movements in interest rates. This may take the form of immunizing net worth or, instead, immunizing the future accumulated value of a fixed-income portfolio. Immunization of a fully funded plan is accomplished by matching the durations of assets and liabilities. To maintain an immunized position as time passes and interest rates change, the portfolio must be periodically rebalanced. Classic immunization also depends on parallel shifts in a flat yield curve. Given that this assumption is unrealistic, immunization generally will be less than complete. To mitigate the problem, multifactor duration models can be used to allow for variation in the shape of the yield curve.

A more direct form of immunization is dedication, or cash flow matching. If a portfolio is perfectly matched in cash flow with projected liabilities, rebalancing will be unnecessary.

Review the resources listed in the Books and Resources area below to prepare for this week's assignments.

Book:

Investments

Bodie, Z., Kane, A., & Marcus, A. J. (2013). Investments New York, NY McGraw-Hill-Irwin.

Read Chapter 16

Investing in Bonds YouTube Video:

https://youtu.be/_7e4B7LLMeI