SECAN 2

• Interest rates

  Primarily based on three components: Real Risk-Free Rate, Inflation, Risk Premium
• Real Risk-Free Rate


  Government securities such as treasury bills/bonds, t-bonds if long term
• Risk Premium


  Every additional risk, taasan mo ang risk premium mo
• Maturity


  Length in which investment is locked in
• Longer the maturity


  Higher the volatility of the bond
• Very short term


  Not much returns
• Longer term


  Much preferable
• Duration


  Answers the effect of interest change on bond price
• If interest rate declines

  Bond price increases
• If interest rates go high

  Bond price would go down
• Macaulay duration


  Introduced by Frederick Macaulay, used as basis for modified duration

  
• Modified duration


  A factor in determining the bond price volatility, always lower than Macaulay duration

  
• Effective duration


  Answers how big or low the price will change based on how the interest rates would go up or down

  
• Computing Macaulay duration


  1. Tabulated formula or Macaulay duration formula

  2. Macaulay duration is lower than actual maturity

  
• Computing modified duration


  1. Get the present value of all cash flows during the time that you have invested the bond

  2. Divide the PV by the bond price

  
• Macaulay duration


  Indicates when you will be earning, can show if bond is okay to invest in
• Modified duration


  Always negative to reflect inverse relationship of interest and price
• Bond price volatility


  Bond price movements vary proportionally with modified duration for small changes in yields
• Longest-duration security provides the maximum price variation
• If you expect interest rates to rise, you should hold shorter-duration securities

  
• Trading Strategies Using Modified Duration

  • Longest-duration security provides the maximum price variation
  • If you expect interest rates to decrease, increase the average modified duration of your bond portfolio for maximum price volatility (vice versa)
  • The greater duration of the bond, the greater its percentage price volatility
• Effective duration


  Talks about percentage change in price, the answer would be percent
• Empirical duration


  Not used much, considered subjective, relies heavily on experiences, historical or actual perception of experts
• Arbitrage Pricing Theory


  Variables are added to know the stock price or expected return, made based on the experiences of the analysts
• Portfolio duration


  Would not always be expressed in years unless stated, in the given problem it is the interest rate sensitivity

  
• Convexity


  A smoothening factor, computed if there's a tiebreaker on duration or if the changes of interest rates from one period to another is very big

  
• Spread


  Difference between bid and ask
• OAS (Option Adjusted Spread)


  Special type of spread because it considers a bond with embedded features, so it would possibly have higher callability or putability
• 1. spread


  Encountered when calculating accrued bond, component of traditional bond spread specially when there is embedded option
• Option-free bond


  A raw bond with no embedded features
• Derivatives


  • Process of financial engineering
  • Structuring a specific underlying asset and valuing it given a specified period of time and expiration date
• Types of Derivatives


  • Options
  • Futures
  • Forwards
  • Swaps
• Tangible commodities

  Metals, corn, coffee, wheat, sugar, cotton
• Intangible commodities


  Methane, butane, ethanol, petroleum products, mercury
• Derivatives Elements: contract, agreement, participants, underlying asset, maturity
• exotics

  • engages in more complex activities and usually they are hybrid in nature
• greeks- alpha/beta
• swaps are often attributed to interest and currency values
• forwards are used to hedge or mitigate the price movement risk by locking the price today for the transaction to occur at a future date
• forward contracts have no transaction cost