Reading 29: Fixed Income Portfol....ement - Part II－LOS j advantages, across

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 CFA Institute Area 8-11, 13: Asset Valuation
Session 9: Portfolio Management of Global Bonds and Fixed Income Derivatives
Reading 29: Fixed Income Portfolio Management - Part II
LOS j: Illustrate how breakeven spread analysis can be used to evaluate the risk in seeking yield advantages across international bond markets.

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Which of the following most accurately describes the purpose of using break-even analysis (forward rates) to make relative value decisions? Break-even analysis is used to determine:

A) the credit risk isolated from interest rate risk for different markets.

B) whether a cross or a proxy hedge should be used.

C) whether or not to hedge.

D) the currency risk isolated from interest rate risk for different markets.

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Answer and Explanation

The strategic outlook is what you "expect" to happen to the currency. The market price can be determined from the forward rate. Comparing the two dictates whether you should hedge or not hedge (which is the ultimate decision).

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Which of the following is TRUE concerning how breakeven rate analysis can be used to make relative value or currency hedging decisions between foreign bond markets? Break-even analysis can be used to:

A) quantify the correct amount of currency exposure to hedge.

B) quantify the amount of spread widening that would erase the yield advantage from investing in a higher yielding market.

C) quantify risk differences between a cross hedge and a proxy hedge.

D) identify mispriced bonds in foreign markets and to take advantage of the mispricing.

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Answer and Explanation

Breakeven rate analysis can be used to determine how many basis points the spread would have to change in order for yield advantages to be eliminated.

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Mary Brickland, CFA, is analyzing two different domestic bonds. Bond A has the longer modified duration at 9.50 with a yield of 9.12 percent. Bond B has a modified duration of 7.30 and a yield of 7.80 percent. Brickland has an investment-holding period of one year and expects a favorable credit quality change for Bond B to increase its market value during this time frame. If Brickland buys Bond B, what is the required basis point change in the spread (in terms of the required yield on Bond B) to offset Bond As yield advantage?

A) 13.89474 bp due to a decline in the yield.

B) 14.72190 bp due to an increase in the yield.

C) 17.11543 bp due to an increase in the yield.

D) 18.08219 bp due to a decline in the yield.

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Answer and Explanation

Bond A has a yield advantage of 132 basis points relative to Bond B. An increase in Bond Bs credit rating will lower its required yield, which will increase its market value. Since we are looking at this in terms of Bond B: (-1.32/-7.30) x 100 = +18.08219bp, implying that the spread must increase by 18.08219 basis points. Hence, in terms of the yield on Bond B, the breakeven change in yield is 18.08219bp, or a decline in the yield on Bond B (thus resulting in the widening of the spread between A and B by this amount). This change will result in capital gains for Bond B, which will offset As original yield advantage.

Bond A has a yield advantage of 132 basis points relative to Bond B. An increase in Bond Bs credit rating will lower its required yield, which will increase its market value. Since we are looking at this in terms of Bond B: (-1.32/-7.30) x 100 = +18.08219bp, implying that the spread must increase by 18.08219 basis points. Hence, in terms of the yield on Bond B, the breakeven change in yield is 18.08219bp, or a decline in the yield on Bond B (thus resulting in the widening of the spread between A and B by this amount). This change will result in capital gains for Bond B, which will offset As original yield advantage.