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Tyler Austin is a fixed-income portfolio manager at Laredo Advisors. He manages a USD($)1 billion fund that opportunistically seeks the best ideas across fixed-income markets. He meets daily with Odessa Houston, the fund's senior analyst, to discuss trade ideas that might be implemented that day. Austin has identified six ideas that he would like Houston to evaluate in more detail for potential inclusion in the fund.Austin notes that the current low level of interest rates is limiting the potential absolute return the fund generates. He asks Houston to evaluate the use of leverage to enhance returns. He can borrow 25% of the fund's value at an annual interest rate of 1.50% and earn a rate of return of 5% per year on the invested funds.Austin tells Houston that he is concerned about the potential for rates to rise and wants to explore how the fund's duration can be changed using the futures market. The fund currently has duration of 5, and he would like to eliminate all interest rate risk. Houston uses the data in Exhibit 1 for her analysis. Austin is intrigued by the incremental yield he could earn by buying an Italian sovereign bond. A dealer provides a quote at a spread of 350 basis points over U.S. Treasuries for a 5% coupon, 10-year maturity Italian Buoni Del Tesoro Poliennali (BTP) bond with duration of 6.75. He asks Houston to assess how much this bond spread could widen over the six-month period he intends to hold the bond before the yield advantage relative to Treasuries would be eliminated.Austin asks Houston whether the euro-denominated bonds they buy should be hedged back to the U.S. dollar, the fund's domestic currency. Houston responds that they should hedge back to the U.S. dollar because short-term interest rates are 2.50% in the eurozone and 0.25% in the U.S. and her forecast shows that she expects the euro to depreciate by 1.75% relative to the U.S. dollar.There are U.S.-denominated and euro-denominated bonds in the fund; therefore, Austin wonders whether the fund's duration is still simply an average of the durations of each bond. Houston comments, "International interest rates are not perfectly correlated. Currently, the fund has 80% of the portfolio in U.S. issuers with average duration of 5.5 and the remainder in German issuers with average duration of 3.5. Historically, the country beta of Germany—i.e., for German rates relative to U.S. rates—is estimated to be 0.62."Finally, Austin tells Houston that his models are showing mortgage securities as having the most attractive spread relative to other fixed-income sectors. He believes there are certain risks associated with mortgages and would like to hedge them. He asks Houston to identify the risks and possible ways to hedge them. Houston replies with the following statements:Statement 1: Option-adjusted spread (OAS) is the risk premium for holding mortgage securities; therefore, you don’t want to hedge this spread risk. If you do hedge against the spread widening, you’ll also give up the benefit from the spread narrowing. If you believe yield spreads are wide, try to capture the OAS over time by increasing the allocation to mortgage securities.Statement 2: The durations of mortgage securities change in an undesirable way when interest rates change. You can effectively manage this negative convexity by buying options or by hedging dynamically. Hedging dynamically with futures requires lengthening duration after rates have declined and shortening it after rates have risen. The cost associated with dynamically managing negative convexity is forgoing part of the spread over Treasuries.Statement 3: You can manage volatility risk by buying options or by hedging dynamically. When the volatility implied in option prices is higher than you believe future realized volatility will be, you should hedge by purchasing options. When you believe future volatility will be higher than implied volatility, you should hedge dynamically. |
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