Breakeven Analysis (fixed income reading under currency risk) is calculated by
Yield Spread DIVIDED BY duration, and the result is the spread widening that would negate foreign bond yield spread.
My question is, which duration do I use? Duration of domestic bonds or duration of foreign bonds?
In one of the 2014 AM exams, the answer key says that I should be using HIGHER of the two durations. Is this always the case? In what situation do I choose specifically foreign bond duration, and in which situation do I choose higher of the two.
For example, if you purchase a US bond and want to calculate breakeven for a quarter vs a JGB with yields of 4.62% and 2.74%, respectively, initial spread is positive (i.e. 4.62% - 2.74% / 4 = +47 bps).
US Duration = 7.79
Japan Duration = 8.19
Breakeven: 47bp = 8.19(BES) —> BES = 5.7 bp (higher yield bond underperforms if spread increases)
Example 2:
if you purchase a US bond and want to calculate breakeven for a quarter vs a Bund with yields of 4.62% and 5.04%, respectively, initial spread is negative (i.e. 4.62% - 5.04% / 4 = -10.5 bps).
US Duration = 7.79
German Duration = 7.34
Use lower duration
Breakeven: 10.5 bp=-7.34(BES) —> BES = 1.4 bps (lower yield bond will outperform if spread increases)
We use the lower duration here for a more conservative (larger) spread change required to breakeven.
Well, it seems unlikely that we’d get a scenario like Example 2 on the exam then because the curriculum specifically says “… the breakeven spread widening analysis … must be based on the higher of the two countries’ durations.”
Thank you for a good explanation. This makes perfect sense from a practical perspective. Does this approach match what the CFAI uses in its study materials and tests?
My concern is that if we try to be too smart in our nuanced answers, graders will ignore our explanation if it doesn’t match a response template given to them by the CFAI.
Choose the higher duration when nothing is specified
Choose the duration of the bond A if the question explicitly asked ‘how much the spread of Bond A should change’. Sometime Bond A is not explicitly mentioned but the case situation shouts it out.