Breakeven Spread Analysis

CFA Level III
#1

Average Yield of Domestic Bonds in Current Portfolio: 3%

Average Yield of Foreign Bonds: 6.2%

Duration of Current Portfolio: 5

Duration of Foreign Bonds: 5

Foreign Country Beta relative to Domestic Country: 0.35

Question: what is the spread widening that would eliminate the foreign bond’s yield adevantage??

answer is (6.2% - 3) / 5 = 64bps change in interest rates

Why isn’t the Country beta used here? shouldn’t it be (6.2% - 3) / (5 * 0.35) ???

#2

You use country beta to see the change in portfolio value when foreign bond yield changes.

The yield advantage is the difference between the two yields, so the change in spread can happen from movements in either end or even movements simultaneously. The difference is an absolute figure if you will and it doesn’t recognize which is foreign which is domestic.

The distance between town A and B is 10 km. It is the same for the inhabitants of both towns.

#3

Yield beta is used in calculation of Change in Foreign bond Value (when domestic rates change), that is,

Change in Foreign bond Value (when domestic rates change) = Duration × yield beta × ∆ Domestic yield × 100

and Duration Contribution of Foreign Bond = wF × DF × Country beta

Portfolio duration = Duration Contribution of Domestic Bond + Duration Contribution of Foreign Bond

In break-even analysis, it is not used. Further, it is important to remember that in break-even spread should be calculated using the higher of the two countries’ durations.

#4

You also need to remember to use the higher of either two bond’s durations for the reasons mentioned above, and adjust the yield according to the question’s timeframe.

#5

thanks all, very helpful

#6

so in duration contribution, use country beta… in breakeven spread analysis country beta is irrelevant – right?

#7

Correctamundo!

#8

I thought country beta shows the change of foreign WHEN domestic changes. That is the effect of a domestic yield change on a foreign bond.

Yup: reviewed it. Example 16: For a X change in domestic, the foreign changes by Y.

#9

is this still relevant for 2019? Haven’t seen anything so far but just wanted to confirm in case I missed anything… I came across this question doing CFAI 2016 AM, question 2A/B

#10

It’s not.