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Lecture Derivatives: An introduction: Chapter 12 - Robert A. Strong

Lecture Derivatives - An introduction: Chapter 12 - Futures contracts and portfolio management. The main contents of the chapter consist of the following: The concept of immunization, altering asset allocation with futures. | © 2004 South-Western Publishing Chapter 12 Futures Contracts and Portfolio Management Outline The concept of immunization Altering asset allocation with futures The Concept of Immunization Introduction Bond risks Duration matching Duration shifting Hedging with interest rate futures Increasing duration with futures Disadvantages of immunizing Introduction An immunized bond portfolio is largely protected from fluctuations in market interest rates Seldom possible to eliminate interest rate risk completely A portfolio’s immunization can wear out, requiring managerial action to reinstate the portfolio Continually immunizing a fixed-income portfolio can be time-consuming and technical Bond Risks A fixed income investor faces three primary sources of risk: Credit risk Interest rate risk Reinvestment rate risk Bond Risks (cont’d) Credit risk is the likelihood that a borrower will be unable or unwilling to repay a loan as agreed Rating agencies measure this risk with bond ratings Lower bond ratings mean higher expected returns but with more risk of default Investors choose the level of credit risk that they wish to assume Bond Risks (cont’d) Interest rate risk is a consequence of the inverse relationship between bond prices and interest rates Duration is the most widely used measure of a bond’s interest rate risk Bond Risks (cont’d) Reinvestment rate risk is the uncertainty associated with not knowing at what rate money can be put back to work after the receipt of an interest check The reinvestment rate will be the prevailing interest rate at the time of reinvestment, not some rate determined in the past Duration Matching Introduction Bullet immunization Bank immunization Introduction Duration matching selects a level of duration that minimizes the combined effects of reinvestment rate and interest rate risk Two versions of duration matching: Bullet immunization Bank immunization Bullet Immunization Seeks to ensure that a . | © 2004 South-Western Publishing Chapter 12 Futures Contracts and Portfolio Management Outline The concept of immunization Altering asset allocation with futures The Concept of Immunization Introduction Bond risks Duration matching Duration shifting Hedging with interest rate futures Increasing duration with futures Disadvantages of immunizing Introduction An immunized bond portfolio is largely protected from fluctuations in market interest rates Seldom possible to eliminate interest rate risk completely A portfolio’s immunization can wear out, requiring managerial action to reinstate the portfolio Continually immunizing a fixed-income portfolio can be time-consuming and technical Bond Risks A fixed income investor faces three primary sources of risk: Credit risk Interest rate risk Reinvestment rate risk Bond Risks (cont’d) Credit risk is the likelihood that a borrower will be unable or unwilling to repay a loan as agreed Rating agencies measure this risk .