Relative Valuation Analysis and Arbitrage

 Fixed Income Arbitrage Strategies
 Fixed Income Hedging Strategies

 Fixed Income Investment in foreign markets
2
Arbitrage Strategies for Fixed Income Portfolio
Arbitrage 
The practice of taking advantage of a price differential between
different instruments and/or markets
Idea  Buy low , Sell high  use of “Relative Valuation Analysis”
Example:
If the price of Microsoft stock on the NASDAQ is traded at 30 USD/share and its
corresponding futures contract on the CME is traded at 2950 USD/contract in which
one contract will delivered 100 shares of Microsoft. one can buy the less expensive
instrument (Futures) and sell the more expensive (common stock). The differential is
the arbitrage profit that arbitrageur would receive (0.5USD/Share).
4
Arbitrage Strategies for Fixed Income Portfolio
Relative Valuation Analysis

 Yield Spread Arbitrage (Cheap/Rich, OAS)
 Term Structure Arbitrage (Forward Rate and Arbitrage)
 Convertible Arbitrage
 On-the-run and Off-the-run Arbitrage
 Bond Swaps
5
Yield Spread Arbitrage 

Comparing spread of the bond over some benchmark to
the required spread and determining whether the bond is
“overvalued” or “undervalued” relative to the benchmark
Complication
1. Too many types of spread !!!
2. Too many types of benchmark !!!
6
Types of spread
1. Nominal Spread
2. Zero Volatility Spread (Z-spread)
3. Option-adjusted Spread (OAS)
7
Types of Benchmark
1. Treasury Benchmark
2. Bond Sector Benchmark (usually higher-rated bond
within the same sector)
3. Issuer-Specific Benchmark
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Cheap/Rich
 “Cheap” / “Undervalued”
 spreads larger than required spread
 “Rich” / “Overvalued”
 spreads smaller than required spread
 “Fair” / “Properly valued”
 spreads equal to the required spread
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Example:
A callable corporate ABC bond has nominal spread relative to
treasury yield curve at 240 bps, Z-spread relative to Treasury spot
curve at 200 bps, OAS relative to Treasury spot curve at 180 bps. If
a comparable option-free XYZ bond in the market has Z-spread of
200 bps. Determine whether ABC bond is overvalued, undervalued,
or properly valued relative to XYZ bond?
Answer: ABC is “Overvalued” relative to XYZ
Strategy: Long XYZ bond and short ABC bond
10
This is OAS
spread!!
Source: Bloomberg
11
Forward Rate and Arbitrage
Idea:
“Current forward rate approximately reflects expectation on future rates”
Forward rate = (1  Z1 ) * (1 1 f1 ) (1  Z 2 ) 2
Example: 1-year zero coupon bond yield is 6%, 2-year zero coupon bond
yield is 8%, then 1 year forward rate one year from now =
(1  0.06) * (1 1 f1 ) (1  0.08) 2   1 f1 10.04%
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Forward Curve and Spot Curve
March 1, 2004 March 1, 2004
USD Libor USD Forward Curve
Exhibit 1 Exhibit 3
1 month 1.10000 0x1 1.10000
2 month 1.11000 1x2 1.11927
3 month 1.12000 2x3 1.13754
4 month 1.13000 3x4 1.15735
5 month 1.15000 4x5 1.22402
6 month 1.17000 5x6 1.26254
7 month 1.19375 6x7 1.33145
8 month 1.22125 7x8 1.40115
9 month 1.25000 8x9 1.47255
10 month 1.29000 9x10 1.62928
11 month 1.32875 10x11 1.69269
12 month 1.36750 11x12 1.81135
Source: BBA One-month forward rates

calculated from the spot Libor
rates of Exhibit 1.
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Forward Rate and Arbitrage
What if market expectation for 1f1 is 8%, what is the implication?
 Yield of 2-year zero coupon bond falls to around 7%
 Or, Yield of 1-year zero coupon bond rises to around 8%
 Or, combination of both.
  “flattening yield curve”
Strategy:
 Short 1-year bond and long 2-year bond for expected capital gain
14
Convertible Arbitrage
 involves purchasing a portfolio of convertible securities, generally
convertible bonds, and hedging a portion of the equity risk by selling
short the underlying common stock to make portfolio “Delta-neutral”
Idea:
Convertible bond is sometime price inefficiently relative to underlying
stock due to
1. Lack of liquidity
2. High Volatility in Interest rate
3. market psychology
15
Example:
Convertible bond of ABC corporation is priced at 850 with
conversion ratio of 100. ABC common stock is currently traded at 9.
What would be the profit from implementing convertible arbitrage
strategy?
Answer: arbitrage profit would be 0.5 per share.
What if price of ABC stock changes??
16
Risks associated with Convertible Arbitrage Strategy
 Equities Risk
 Interest rate Risk
 Credit Risk
 Liquidity Risk
Note:
Both prices of convertible bond and common stock could simultaneously
move at different rate.
 Required “Dynamic Delta Hedging”
 Quite demanding and costly
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On-the-run and Off-the-run

“ On-the-run”  newest issued securities of a given series
“ Off-the-run”  previously issued securities
Idea: “On-the-run” issues have the largest trading volume  higher liquidity
 Less liquidity Risk  lower required spread  Disparity between
“On-the-run” and “Off-the-run” yield
Recall: Disparity creates “Arbitrage Opportunities”
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Spread b/w “On-the-run” and “Off-the-run”

Spread = “Off-the-run” yield – “On-the-run” yield
Example: 10-year bonds “On-the-run” yield is 3.85% and
“Off-the-run” yield is 3.9%, the spread is 5 bps
 See that price of “On-the-run” is more expensive than
“Off-the-run” securities
 Usually, due to heavy arbitrage activities, yield converge
to be very close as time pass
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Source: Bloomberg
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Sample of On-the-run and Off-the-run Yield Spread
Source: Federal Reserve, Columbia University Archive 2003

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Bond Swaps
 In a bond swap, a portfolio manager exchanges an
existing bond or set of bonds for a different issue
 Bond swaps are intended to:
 Increase current income
 Increase yield to maturity
 Improve the potential for price appreciation with a decline in
interest rates
 Establish losses to offset capital gains or taxable income
22
Bond Swaps
Types of Bond Swaps
 Substitution swaps / Yield Pick up swaps
 Intermarket or yield spread swaps
 Bond-rating swaps
 Quality swaps
 Rate anticipation swaps
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Substitution Swaps / Yield Pick
up Swaps
 In a substitution swap, the investor exchanges one bond
for another of similar risk and maturity to increase the
current yield
Strategy:
Find identical bonds which do not yield the same rates

 Long in the underpriced ( higher yielding ) bond ,
Short in the overpriced ( lower yielding ) bond .
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Substitution Swaps / Yield Pick
up Swaps
Example:
Selling a XXX bond with 8% coupon for par and buying
a YYY bond with 8% coupon for $980
Outcome: immediate profit is pick up in the current yield
by 16 basis points
Note:
 Profitable substitution swaps are inconsistent with market
efficiency
 Obvious opportunities for substitution swaps are rare
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Intermarket or Yield Spread
Swaps
 The intermarket or yield spread swap involves
bonds that trade in different markets/sectors
 i.e., government versus corporate bonds
 Small differences in different markets can cause

similar bonds to behave differently in response to
changing market conditions
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Intermarket or Yield Spread
Swaps
 In a flight to quality, investors become less
willing to hold risky bonds
 As investors buy safe bonds and sell more risky bonds,
the spread between their yields widens
 Flight to quality can be measured using the
confidence index
 The ratio of the yield on AAA bonds to the yield on
BBB bonds
27
Bond-Rating Swaps
 A bond-rating swap is really a form of intermarket
swap
 If an investor anticipates a change in the yield spread,
he can swap bonds with different ratings to produce a
capital gain with a minimal increase in risk
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Quality Swaps
 Strategy of buying bonds with high or low quality
rating based on the expectation of a change in
economic states.
Strategy:
Expect recession  Long in high quality bonds ,

Short in low quality bonds
Expect exp ansion  Long in low quality bonds ,

Short in high quality bonds
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Rate Anticipation Swap
 In a rate anticipation swap, the investor swaps bonds with
different interest rate risks in anticipation of interest rate
changes/ Yield curve shifts.
Strategy:
Expect r  and  P0B  across all maturity  Long in high duration bonds
Expect r  and  P0B  across all maturity  Long in low duration bonds
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Long-Term Capital Management
Case (LTCM)
Background
 Found in 1994 by a group of ex Solomon Brothers Traders
 Joined by 2 prominent academia  Merton and Scholes
 Average annualized return on the first several years was
approximately 40%
 Collapse in 1998, in which lost $4.6 billion in 4 months
 Bailed-out orchestrated by FBNY along with other key
major investment banks
 Officially liquidated in early 2000
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Case (LTCM)
Trading Strategies Involved
 Convertible Arbitrage
 “On-the-run” / “Off-the-run” Arbitrage
 Yield Curve Arbitrage
 Along with usage of Derivatives to enhance return
32
Case (LTCM)
Sample of On-the-run” and “Off-the-run” Arbitrage practice by LTCM
Source: Federal Reserve, Columbia University Archive 2003

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Case (LTCM)
Key Profit Generation
 Leverage  some speculate that the number was > 100:1
Example:
 LTCM bought $1 billion of “Cheap” off-the-run bond
 Short $1 billion of “expensive” on-the-run
 Off-the-run position is used as collateral for on-the-run
 Results is no money need to pay upfront.
 If everything works as planned (when “on-the-run” and “off-the-
run” rates converge), profit would be 15 millions from this
transaction
34
Case (LTCM)
Trigger of the fall
 Russian bond defaulted in 1997  Flight to Quality 
Spread rise between Emerging markets and US bonds,
Spread rise between “On-the-run” and “Off-the-run”
 Multiply effect with Large position in derivatives for
leverage  Dooms Day solution !!!
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Hedging Strategies for
Fixed Income Investment
Hedging Strategies for Fixed Income Investment
 Portfolio Immunization
 Laddered Portfolio
 Derivatives and Hedging Strategies for Fixed Income
Investment
 Bond Futures
 Option
37
Portfolio Immunization
 If the average duration of a portfolio equals the
investor’s desired holding period, the effect is to
hold the investor’s total return constant regardless
of whether interest rates rise or fall.
 In the absence of borrower default, the investor’s
realized return can be no less than the return he has
been promised by the borrower.
38
Example – Portfolio
Immunization
 Assume we are interested in a $1,000 par value
bond that will mature in two years.
 The bond has a coupon rate of 8 percent and pays
$80 in interest at the end of each year.
 Interest rates on comparable bonds are also at 8
percent but may fall to as low as 6 percent or rise
as high as 10 percent.
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Example – Portfolio
Immunization
 The buyer knows he will receive $1000 at
maturity, but in the meantime he faces the
uncertainty of having to reinvest the annual $80 in
interest earnings at 6%, 8%, or 10%.
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Example: Case 1
 Let interest rates fall to 6%.

 The bond will earn $80 in interest payments for year
one, $80 for year two, and $4.80 ($80 x 0.06) when the
$80 interest income received the first year is reinvested
at 6% during year 2.
41
Example: Case 1
 How much will the investor earn over the two

years?
 First year’s interest earnings + Second year’s interest
earnings + Interest earned reinvesting the first year’s
interest earnings at 6% + Par value of the bond at
maturity.
 $80 + $80 + $4.80 + $1,000 = $1,164.80
42
Example: Case 2
 Let interest rates rise to 10%.

43
Example: Case 2

years?
maturity.
 $80 + $80 + $8 + $1,000 = $1,168.00
44
Immunization and
Duration
 The investor’s earnings could drop as low as
$1,164.80 or rise as high as $1,168.
 But, if the investor can find a bond whose duration
matches his or her planned holding period, he or
she can avoid this fluctuation in earnings.
 The bond will have a maturity that exceeds the
investor’s holding period, but its duration will match it.
45
Recall Example: Case 1
 Let interest rates fall to 6%.

 But, the bond’s market price will rise to $1,001.60 due
to the drop in interest rates.
46

years?
interest earnings at 6% + Market price of the bond at
the end of the investor’s planned holding period.
 $80 + $80 + $4.80 + $1,001.60 = $1,166.40
47
 Let interest rates rise to 10%.

 But, the bond’s market price will fall to $998.40 due
to the rise in interest rates.
48

years?
maturity.
 $80 + $80 + $8 + $998.40 = $1,166.40
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Portfolio Immunization
 The investor earns identical total earnings whether interest rates go
up or down.
 With duration set equal to the buyer’s planned holding period, a
fall (rise) in the reinvestment rate is completely offset by an
increase (a decrease) in the bond’s market price.
 Immunization using duration seems to work reasonably well because
the largest single element found in most interest rate movements is a
parallel change in all interest rates (explains about 80% of all interest
rate movements over time).
 So, investors can achieve reasonably effective immunization by
approximately matching the duration of their portfolios with their
planned holding periods.
50
Opportunity Cost and Portfolio
Immunization
 Duration is not free. There is an opportunity cost.
 If the investor had simply bought a bond with a
calendar maturity of two years and interest rates rose,
he or she would have earned $1,168.
 The opportunity cost of immunization is a lower, but more
stable, expected return.
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Limitation of Portfolio
Immunization
 In reality it can be difficult to find a portfolio of
securities whose average portfolio duration
exactly matches the investor’s planned holding
period.
 As the investor grows older, his planned holding period
grows shorter, as does the average duration of his
portfolio, but they may not decline at the same rate.
 Portfolio requires constant adjustments.
52
Limitation of Portfolio
Immunization
 Many bonds are callable so bondholders may find
themselves with a sudden and unexpected change
in their portfolio’s average duration.
 The future path of interest rates cannot be
perfectly forecast; therefore, immunization with
duration cannot be perfect without the use of
complicated models.
53
Contingent
Immunization
 Contingent Immunization is a mixed of both an active and
passive strategy.
 Bond manager pursues an active bond strategy until an
agreed-upon minimum rate is reached or safety margin
approaches zero; when that occurs the manager immunizes
the position.
54
Contingent
Immunization
Example:
 Suppose an Investment Company offers a contingent immunization
strategy for investors with HD = 3.5 years based on a current 4-year, 9%
annual coupon bond trading at a YTM of 10% (assume flat YC at 10%).
The bond has a duration of 3.5 years and an immunization rate of 10%,
in which assumes that minimum target rate is approximately 8%.
Strategy:
the investment will be immunized when the following case occurs
 The minimum target rate is reached 8%
 The investment’s safety margin is zero:
55
Contingent
Immunization
 Suppose the investment company has a client with $1M
to invest and HD = 3.5 years.
 Client’s Initial Safety Margin (SM):
Inv
SM 0 V 0  PV ( Funds Needed to hit 8%)
$1 M (1.08) 3.5
SM 0  $1 M  3.5  $62,223
(110
. )
56
Contingent
Immunization
 As part of its active strategy, suppose the investment company invest the
client’s funds in a 10-year, 10% annual coupon bond trading at par.
 Scenario 1: One year later the YC shifts down to 8%
 Client’s Safety Margin (SM):
Value of original 10  year bond :
9
10 100
V 9
B
 t  9  112.94
t 1 (1.08) (1.08)
Inv  112.94 
V   ($1 M )  .(10)($1 M )  $1.225 M
 100 
$1.309 M
Min T arg et Value   $1 M
(1.08) 2.5
SM  $1.225  $1 M  $0.225 M
57
Contingent
Immunization
 With a positive SM, the company could maintain its current
investment, pursue a different active strategy, or it could
immunized the position.
 If the company immunizes, it would liquidate the original 10-
year bond and purchase a bond with HD = 2.5 years yielding
8% (assume flat YC at 8%). If it did this, it would be able to
provide the client with a 11.96% rate for the 3.5 year period:
58
Contingent
Immunization
 Scenario 2: One year after investing in the 10-year bond, the YC shifts up to
12.25%.
 Client’s Safety Margin (SM):
Value of original 10  year bond :

9
10 100
V9
B
 t  9  88.124
t 1 (11225
. ) (11225
. )
Inv  88.124 
V   ($1 M )  .(10)($1 M )  $981,657
 100 
$1.309 M
Min T arg et Value  2 .5  $980,657
(11225
. )
SM  $981,245  $980,657  $585  0
59
Contingent
Immunization
 With the SM approximately zero, the company would
immunized the position.
 The company would liquidate the original 10-year bond and
purchase a bond with HD = 2.5 years, yielding 12.25%
(assume flat YC at 12.25%). For the 3.5 year period the rate
would be the minimum target rate of 8%:
1/ 3.5
 $0.981 M (11225
. ) 2 .5

Rate     1  .08
 $1 M 
60
Laddered Portfolio
 In a laddered strategy, the fixed-income dollars
are distributed throughout the yield curve
 A laddered strategy eliminates the need to
estimate interest rate changes
 For example, a 1 million portfolio invested in
bond maturities from 1 to 25 years (see next slide)
61
Laddered Portfolio
50000
Par Value Held ( in Thousands)
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1 3 5 7 9 11 13 15 17 19 21 23 25
Years Until Maturity
62
Laddered Portfolio
 In laddered portfolio, the principal proceeds from the matured bond
will be reinvested at the longer end of the ladder, often at higher
interest rate.
Portfolio Return and rate scenarios
 Unchanged Rate  return is stable and fairly closed to the highest
yield in portfolio
 Rising Rate  return drop at first and recover later from reinvest in
longer term bonds at the lower cost
 Falling Rate  return rise at first and drop later from reinvest in
longer term bonds at the higher cost
63
Laddered Portfolio
Source: Thornburg Financial
64
Derivatives in Fixed-Income
Management
Primary Usage
 Derivatives (i.e., Futures, Swap, and Option) can be used to modify portfolio
risk and return
 Using derivative for asset allocation  “portable alpha”??
 Adjusting allocations in the underlying assets can be very expensive
 Less costly to achieve a similar asset allocation exposure using derivatives,
especially for temporary adjustments
 To control portfolio cash flows
 Hedging portfolio cash inflows and outflows
 Hedging instruments against risk factors, i.e., interest rate risk
 Target duration = Contribution of current bond portfolio + contribution of
the futures component
65
Futures
 Treasury bond futures contract
 Typically used contract for risk management of fixed-
income portfolios
 Deliver pre-specified T-bonds at the expiration
 Those that are delivered are the cheapest-to-deliver (CTD)
that satisfies contract
 Most common usage  Duration Hedging
66
Futures
Determining How Many Contracts to Trade to Hedge a portfolio position
 determine “Hedge Ratio”
Cash Flow
Hedge ratio = Value of 1 Contract Conversion Factor Duration Adjustment Factor
 Conversion factor
 Adjusts the CTD bond to 8% (required for delivery)
 Duration adjustment factor (DAF)
 Reflects the difference in interest rate risk between the CTD bond
and the portfolio being hedged
MD portfolio ,t
DAF 
MD futures ,t
67
Futures
Example:
Suppose there is a 6-month hedging horizon and a portfolio value of $100
million. Further assume that the matching instrument is T-bond futures
contract, which is quoted at 105-09 with the contract size of $100,000. The
duration of the portfolio is 10, and the duration of the futures contract is 12.
What is the contract no. required to trade to completely hedge this portfolio
against small changes in yield?
100,000,000 *10
Answer: N 791.53
105,281.25 *12
But because we long bonds, therefore to make the portfolio Duration-
Neutral, the manager needs to short 792 contracts of T-bond futures
68
Futures
Using Futures in Passive Fixed-Income Portfolio
Management
 Will use futures primarily to manage Cash flow
assets and liabilities
 Will not use futures to actively adjust duration
due to interest forecasts
69
Futures
Using Futures in Active Fixed-Income Portfolio Management
 Modifying systematic risk
 Changing the portfolio duration in light of interest rate forecasts
 Lengthen duration if rates are expected to fall
 Modifying unsystematic risk
 Opportunities are more limited here, but can adjust exposure to
various sectors to take advantage of expected yield changes
70
Futures
Changing the Duration of a Corporate Bond Portfolio
 There are no corporate bond futures contracts, so
strategies are based on using T-bond futures
 Corporate bond yields also impacted by changes in default risk,
unlike T-bond yields
 T-bonds are a “cross hedge” instrument
 Differences could impact the number of contracts required to
hedge a corporate bond portfolio
71
Futures
Modifying the Characteristics of an International
Bond Portfolio
 Positions in foreign bonds are positions in both
securities and currencies
 Futures and option contracts allow the portfolio
manager to manage the risks of the currency and the
security separately
 In a passive strategy, the manager can hedge the risk exposure
 In an active strategy, the manager can adjust the exposure to
try to benefit from expected changes in exchange rates
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Option
 Use of call, put, or combinations
Practical Fixed Income strategies using options
 Portfolio Insurance  long bonds, long puts
 Covered Calls  long bonds, short calls
 Buy-Writes  long bonds, short calls to the same dealer
at the time of long bonds
 Writing Puts  short puts (naked position)
73
International
Fixed Income
markets
International Fixed Income
markets
 Rational of International Fixed Income Investment
 Styles of International Bond Portfolio Management
 Return of International Bond portfolio and sources of
return
 Currency Hedge Decision
75
markets
Rationales
 Higher return than domestic products
 Broader diversification
 Speculate in FX markets
76
markets
Source: Merrill Lynch, as of 2005

77
markets
78
markets
Styles of International Bond Portfolio Management
 Fundamental style  economic cycle based
 Black-box approach  Quant based
 Experienced traders  experience and intuition to
identify market opportunities  Active approach
 Technicians/ Chartist  technical analysis to timing
buy and sell  Trend Reader
 Benchmarkier  pure passive approach
79
markets
Sample of available benchmarks
 JPMorgan Global Government Bond
 JPMorgan Government Bond EMU
 JPMorgan Emerging Markets Band Index Plus (EMBI+)
 iBoxx Euro Overall
 iBoxx Euro Sovereigns
 iTraxx Asian Series
 etc.
80
markets
Benchmark Dilemma
 Bond inclusion difficulty:
 Size of issuance small
 Credit rating limit varies
 Country weights
 Driven by country budget situation, e.g. Japan
 Market capitalization can change quickly between countries
 Duration between countries indices vary significantly
 Replicability:
 Bid-ask spreads generally wide
 Certain issues see small turnover from buy and hold investor
 Total return approach, focus on alpha generation
81
markets
Return of International Bond portfolio and sources of return
 Total expected portfolio return in manager’s home currency = e (ri)
n
e(rp )  w i * (ri  e H,i )
i 1
 N = number of countries whose bonds are in the portfolio

 W = weight of country i’ s bonds in the portfolio
 ri = expected bond return for country i’ s in local currency
 eH,i = expected percentage change of the home currency with country i’s
local currency  currency return  % depreciation of home currency over
period
82
markets
Example:
Suppose a U.S. portfolio manager invests in US treasury bonds with expected return at
4.5%. He also diversifies his investment global to reduce volatility by investing in a
Japanese Bond and a UK Gilt. Proportion of his investment in US Treasury, Japanese
bond and UK Gilt is 80:10:10. The expected return over the investment holding period of
Japanese bond and UK gilt are 1.2% and 5% respectively. If Japanese Yen depreciates
against USD by 1% and UK sterling depreciates against USD by 0.5% over the
investment period. What should be the expected return of his portfolio?
Answer: expected return = 0.8*4.5 + 0.1*(1.2-1)+0.1*(5-0.5) = 4.07%

He turns to be worse off with his global diversification strategy due to stronger USD
against other currencies.
Question: to hedge or not to hedge???
83
markets
If hedged currency, it means buying “forward contract” and lock in rate
 Total expected portfolio return in manager’s home currency if hedged = e (ri)
n
e(rp )  w i * (ri  f H,i )
i 1
 N = number of countries whose bonds are in the portfolio
 W = weight of country i’ s bonds in the portfolio
 ri = expected bond return for country i’ s in local currency
 fH,i = forward rate discount or premium between the home currency and country i’ s
local currency  f H,i c H  ci
 cH and ci are short-term interest rate in home and country i that matched maturity of
forward rate.
84
markets
Other alternative strategies besides using forward contract
 Cross Hedging
Idea: long bond i, and hedged by long forward to deliver currency j
against currency i  close FX exposure in currency i and
open FX exposure in currency j
Return: CRH ,i ri  f j ,i  eH , j
 Proxy Hedging
Idea: long bond i, leave FX exposure in currency i and short
position in currency j  cheaper to hedged in currency j
Return: PRH ,i ri  eJ ,i  f H , j  eH , j
85
markets
Other considerations
 Taxation
 Regulations and legal system
 Political stability
 Economic Stability
 Liquidity
 Etc.
86
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Relative Valuation Analysis and Arbitrage

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 Fixed Income Arbitrage Strategies

 Fixed Income Hedging Strategies

Idea  Buy low , Sell high  use of “Relative Valuation Analysis”

Relative Valuation Analysis

Yield Spread Arbitrage 

Forward rate = (1  Z1 ) * (1 1 f1 ) (1  Z 2 ) 2

1 month 1.10000 0x1 1.10000

2 month 1.11000 1x2 1.11927

3 month 1.12000 2x3 1.13754

4 month 1.13000 3x4 1.15735

5 month 1.15000 4x5 1.22402

6 month 1.17000 5x6 1.26254

7 month 1.19375 6x7 1.33145

8 month 1.22125 7x8 1.40115

9 month 1.25000 8x9 1.47255

10 month 1.29000 9x10 1.62928

11 month 1.32875 10x11 1.69269

12 month 1.36750 11x12 1.81135

Source: BBA One-month forward rates

What if price of ABC stock changes??

On-the-run and Off-the-run

Recall: Disparity creates “Arbitrage Opportunities”

Spread b/w “On-the-run” and “Off-the-run”

Source: Federal Reserve, Columbia University Archive 2003

Find identical bonds which do not yield the same rates

 Small differences in different markets can cause

Expect recession  Long in high quality bonds ,

Expect exp ansion  Long in low quality bonds ,

Source: Federal Reserve, Columbia University Archive 2003

 Let interest rates fall to 6%.

 How much will the investor earn over the two

 Let interest rates rise to 10%.

 How much will the investor earn over the two

 Let interest rates fall to 6%.

 How much will the investor earn over the two

 Let interest rates rise to 10%.

 How much will the investor earn over the two

Value of original 10  year bond :

Source: Thornburg Financial

Source: Merrill Lynch, as of 2005

 Total return approach, focus on alpha generation

 N = number of countries whose bonds are in the portfolio

Answer: expected return = 0.8*4.5 + 0.1*(1.2-1)+0.1*(5-0.5) = 4.07%

Question: to hedge or not to hedge???

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Answer: expected return = 0.84.5 + 0.1(1.2-1)+0.1*(5-0.5) = 4.07%