breakeven analysis from sch. practice vol1.

no, you don’t have to take into account currency returns. both Schweser and CFAI state this explicity.

strikershank Wrote: ------------------------------------------------------- > if you want the minimal rate shift you use the > bond with teh higher duration (we’ve been over > this with another thread) > > but step away from the books for a second. > > breakeven can happen in TWO directions, spreads > widen or spreads narrow. I don’t think “breakeven spread analysis” is defined to cater for TWO directions. It’s only spread widening, which means either higher yield bond increasing yield, or lower yield bond decreasing yield. Do you have any CFAI or Schweser page reference for this? > And for a widen spread > you use the bond with the bigger yeild. With > spreads narrowing you’ll use the bond with teh > smaller yield. disagree. See above. - sticky

Q15.6 vol 1 exam III PM takes appreciation/depreciation return into consideration for breakeven analysis. i.e. the yield advantage is 1 percentage for a qtr period but that bond’s currency is expected to depreciate by 1.5 so they use +.5 for the other bond.

Striker! Yes! Thank you for bringing up that point!!! IF THEY WANT MINIMAL SPREAD WIDENING, then YES use LARGEST DURATION. That is probably why CFAI says to always use Largest Duration. If they just said how much does Bond A need to widen, then use Bond A’s duration, or if it says Bond B need to Widen then us Bond B’s. Striker I completely forgot about that little tidbit when they ask those questions, got too caught up :slight_smile: THANKS! Now I owe you a pint.

I agree with the majority here. The way I look at this. Bond X yields 4.55%, duration 7 Bond Y yields 7.05%, duration 6 The spread between the two yields in 2.5% with Y plotting over X. After the spread(this is spread between X and Y, and not between either of them over the Treasury yield) widens, one of the following is true: 1) X’s yield stays the same, Y moves up. You need to use duration for X. 2) Y’s yield stays the same, X moves down. You need to use duration for Y. 3) Both X and Y move by different amounts, the net of which is a higher spread between X and Y. Here you need to use both durations. But, you only have one equation and two variables. There can be a range of solutions for how much X and Y move.

I already submitted this problem to Schweser last week. Of course they haven’t responded at all to my inquiry… I want my points back…

fsa-sucker Wrote: ------------------------------------------------------- > I agree with the majority here. > The way I look at this. > > Bond X yields 4.55%, duration 7 > Bond Y yields 7.05%, duration 6 > > The spread between the two yields in 2.5% with Y > plotting over X. > > After the spread(this is spread between X and Y, > and not between either of them over the Treasury > yield) widens, one of the following is true: > > 1) X’s yield stays the same, Y moves up. You need > to use duration for X. I think you should use duration of Y. > 2) Y’s yield stays the same, X moves down. You > need to use duration for Y. Duration of X should be used. > 3) Both X and Y move by different amounts, the net > of which is a higher spread between X and Y. Here > you need to use both durations. But, you only have > one equation and two variables. There can be a > range of solutions for how much X and Y move. I think both CFAI and Schweser try to avoid discussing this scenario, and sticking to the assumption that one interest rate is fixed. Breakeven spread analysis is for comparing 2 international bonds (in 2 different interest rate environments) — check LOS (29.j). So it’s not a bad assumption to say one bond has i change but the other doesn’t. - sticky - sticky

oops. got that switched. you are right.

I was about to write something similar to what fsa-sucker said above, but let me throw a numeric example to prove his point (with which I agree after the correction on switching X and Y). Lets say we have Country A and Country B, with respective Bond A and Bond B. Bond A has duration of 10 and yields 5.0%, Bond B has duration of 20 and yields 6.0%. So from this the difference in yields is 100 bps. So we go ahead and purchase higher yielding bond, Bond B What should happend to eliminate this yield advantage of Bond B? 1) if yield on Bond A decrease by 10 bps, Bond A will increase in price by 1% (or will yield additional 100 bps; 10 bps * 10 duration = 100 bps); since we didn’t buy Bond A, we don’t get any benefit from this price increase but it tell us that tells us that decline in yields by 10 bps is a breakeven point. 2) if yield on on Bond B will increase by 5 bps, Bond B will decrease in price by 1% (or will yield negative 100 bps; 5 bps * 20 duration = 100 bps); this derectly affetcs us, since we are holding Bond B and increase in its yield by 5 pbs eliminates our yield afavntage, so its also breakeven point. In the first case the spread widened by 10 bps, creating a breakeven point and in the second case spread widened by 5 bps also creating a breakeven point. Spread could also widen as a result of changes in yields of both bonds, then as fsa-sucker said, you would use both durations, and by having one equation with 2 uknowns there will a range of possible solutions. Now lets use this “faulty” logic of using just the bond with higher duration. From this logic we would take Bond B duration of 20, do 100 bps / 20 = 5 bps; and “wrongly” claim that the spread has to widen by 5 bps to eliminate the yield advantage. What happens if the yield on Bond A declines by 5 bps. That would satisfy “widen by 5 bps claim”, however in such an event, the price of Bond A would only increase by 50 bps, price of Bond B won’t change. And how can you claim that this gives you a breakeven situation? The bond A is now yielding 5.5% (5% old yield + 50 bps price improvement), Bond B is still yielding 6%. So, you still would prefer Bond B, hence the “widening of spread by 5 bps” blanket claim doesn’t produce a breakeven solution. To conclude, the only statements that can be made in this example are: 1) Breakeven spred is 105 bps (5 bps spread widening) as a result of increase in yield on bond B by 5 bps. 2) Breakeven spread is 110 bps (10 bps spread widening) as a result of decrease in yield on Bond A by 10 bps. 3) There maybe multiple combinations of this statement, but for example: Breakeven spread is 106 (6 bps spread widening) as a result of increase in yield on Bond B by 4 bps and decrease on Bond A by 2 bps. The math for statement #3 is: 4*20 + 2*10 = 100 (i.e., price decline on Bond B is 80 bps, price improvement on Bond A is 20 bps, and boh of this events combined have the same effect of eliminating yield advantage of 100 bps).

I posted this example on breakeven spread last night to clarify the confusion people had. hope it helps

Got an answer from the Schweser Team: > Dear xxxx, The question states to use Bond X versus Bond Y. For the exam you must be prepared to use either bond to calculate your answer. Regards, Schweser staff > Edit: Someone needs to post the excerpt from the question… I don’t recall the exact wording they used.

yeah. schweser book 2, test 2pm 19.6 takes the differing Rf rates of the two bonds into account where the book 1, test 3am 9.d doesn’t take differing Rf rates into account. If I take the different Rf into account . . . you see that Y has an advantage of 2.5% over the year but it is offset by a 2.6% disadvantage in Rf rates. Therefore X has an advantage over Y of .1% over the year, .05% over 6 months. For it to fall .05%/7= .007% that X would have to increase by, right? I guess what I’m wondering is; this is confusing enough, how do I know when to account for Rf differentials and when not to?

fsa-sucker Wrote: ------------------------------------------------------- > I agree with the majority here. > > The way I look at this. > > Bond X yields 4.55%, duration 7 > Bond Y yields 7.05%, duration 6 > > The spread between the two yields in 2.5% with Y > plotting over X. > > After the spread(this is spread between X and Y, > and not between either of them over the Treasury > yield) widens, one of the following is true: > > 1) X’s yield stays the same, Y moves up. You need > to use duration for X. > > 2) Y’s yield stays the same, X moves down. You > need to use duration for Y. > > 3) Both X and Y move by different amounts, the net > of which is a higher spread between X and Y. Here > you need to use both durations. But, you only have > one equation and two variables. There can be a > range of solutions for how much X and Y move. Y has a yield advantage right. so you need to figure out how much Y needs to lose to eliminate this yield advantage, which means you use Y’s duration. If you want to figure out how much X needs to tighten, then you use X’s duration.

by the way, how would you go about finding the break even spread widening if both bonds widen by the same amount? is this even tested? say one bond duration of 5, yield of 6% the other bond duration 7 yield of 5% 7(x)-5(x) = 1% and solve for x?