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Chapala Nandin, CFA, is a senior fixed‐income analyst with Tapi Investments, located in Austin, Texas. She has been approved to hire a junior analyst to assist her. Today, she is interviewing Nirav Gordha, a recent college graduate who interned in another investment firm’s fixed‐income department for two years. Nandin explains to Gordha that her approach to fixed‐income management is based on a thorough understanding of interest rate dynamics and that she will be asking him questions during the interview to determine the extent of his knowledge in this area.To begin, Nandin shows Gordha current Treasury yields compared with the yields one year ago. These data are provided in Exhibit 1. She asks Gordha to characterize the change in the yield curve over the year.  Next, Nandin reminds Gordha that changes in the yield curve can have a large impact on the total return from investing in a portfolio of Treasury securities of various durations over a short period of time. She asks him what yield curve change would have the largest impact on the portfolio’s return. Gordha responds, “A change in the slope has a larger impact on total return than any other change in the yield curve.”Nandin and Gordha discuss the valuation of fixed‐income securities using Treasury spot rates and the construction of the theoretical spot rate curve. Gordha notes that spot rates can be calculated from a variety of Treasury securities and makes three observations:Observation 1: If all Treasury securities are used to calculate the spot rate curve, adjustments should be made for the effects of taxes.Observation 2: If Treasury strip securities are used to calculate the spot rate curve, care should be taken to avoid strips created from principal repayments.Observation 3: If on‐the‐run Treasury securities are used to calculate the spot rate curve, the observed yields for the most recently auctioned securities should be used.Nandin asks Gordha to compare the use of a swap curve with a government bond yield curve as a benchmark of interest rates. Gordha responds, “The credit risk of a country’s swap curve is related to the sovereign risk of its government bonds; However, government bond yields can be affected by technical factors that affect supply and demand and alter yields. These technical factors do not exist in swap markets.”Nandin provides Gordha with information about a portfolio of three bonds, including the key rate durations (KRD) of each bond for the 6‐month, 2‐year, 5‐year, and 10‐year parts of the yield curve. This information is found in Exhibit 2. She asks him to characterize the key rate duration profile of the portfolio.  Nandin tells Gordha it is her practice to monitor changes in yield volatility using the 10 most recent trading days. She annualizes the daily volatility using a 260 trading day assumption. She provides an example using the yields found in Exhibit 3.  |
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