Thank you for reading my post! I saw such an example about breakeven spread analysis -------------- Changes in the spread between domestic and foreign interest rates can diminish the return on a foreign bond investment. Breakeven spread analysis quantifies the amount of spread widening (W) that would eliminate a given yield advantage. For example, if a foreign bond offers a 300 basis point yield advantage (75 basis points per quarter) adn has a duration of 5: •The change in the price of the foreign bond would be 5 X the change in yield or 5W •Breakeven = 0.75% X 5W •W = 0.13% or 13 basis points -------------- The example ends here, would anyone please tell me how should I use the result (13bps)?
A 13 bps increase in foreign interest rates (relative to domestic) would wipe out your 75pbs advantage in yield from using the foreign bond investment. Meaning that 75bps advantage can be wiped out pretty quickly. The higher the duration the quicker it can be wiped out.
mwvt9 Wrote: ------------------------------------------------------- > A 13 bps increase in foreign interest rates > (relative to domestic) would wipe out your 75pbs > advantage in yield from using the foreign bond > investment. > > Meaning that 75bps advantage can be wiped out > pretty quickly. The higher the duration the > quicker it can be wiped out. mwvt9: Do you realize in this formula that the book say ( CFAI) we need to use the higher duration? Is that correct? Because I want to keep it cold in my head that I only need to use the higher duration in my calculation because I refuse to keep any logic since I have so much other stuff to retain. i just want ot make sure. please help!
Yes, you use the bond with higher duration because it is more sensitive to interest rate movement.
ws Wrote: ------------------------------------------------------- > Yes, you use the bond with higher duration because > it is more sensitive to interest rate movement. make perfect sense to me and that all I need to know. Thanks
just for clarity, .0075/5 is 15 bps, not 13.
> For example, if a foreign bond offers a 300 basis > point yield advantage (75 basis points per > quarter) adn has a duration of 5: > > •The change in the price of the foreign bond would > be 5 X the change in yield or 5W > •Breakeven = 0.75% X 5W > •W = 0.13% or 13 basis points > -------------- Are you sure the calculations provided here copied verbatim? Doesn’t make sense to me.
ng30 is right, it should be 15 bp per quarter. this example is not complete bec we are not given the duration of the domestic bond. we always use the higher duration as it is more senstive to i/r change (hence more conservative). example, assumind the duration of the domestic bond is 10, then domestic bond yield need to drop by 75/10 = 7.5 bp per quarter for the bond value to breakeven
I think of the formula like this: Delta-Y / time = Duration-higher * Delta-bps And to see which one goes up/down (I think sketch the two curves (the higher yielding one over the lower yield). And I try to figure out what would happen when the respective yields move. I think there was an example in Schweser that illustrated the change for both bonds (i.e. the yield rose for the higher duration bond, wiping out the yield advantage. I think the yield fell for the lower duration bond, similarly wiping out the yield advantage of the higher yielding bond).
tsx11 and all, I noted this problem too in the Schweser concept checkers where you calculated the breakeven spread from the perspective of each bond. Indeed, in Qbank, you come across questions where it asks you to calculate the breakeven spread “from the perspective of” one of the bonds. Any chance CFAI could throw a curveball at us here? Should we really just rely on doing this calc with the higher duration bond? Thoughts?
while i think as a rule you calculate breakeven spread with the longer duration bond, it’s not always the case. you can do it from either direction depending on who’s view you’re taking. am i wrong to think that? take following schweser example (p.220, #18): A PM with investable funds is considering 2 alternatives: Bond Nominal Yield Duration Australian 7.65% 6.5 New Zealand 6.85% 5.3 If the target holding period is 6 months, by how much would either of the yields on these 2 bonds have to change to offset the current yield advantage of the Australian bond? A. Australian increase by 6 bp, New Zealand decrease by 8 bp B. Australian decrease by 6 bp, New Zealand increase by 8 bp C. Australian increase by 12 bp, New Zealand decrease by 15 bp
answer is A right?
what if one bond has duration has duration of 5 and the other 5.1? won’t they move together?.. i thought that one used one bond’s duration while another used the difference. just from memory
Yup, went through this arguement 100 times last year. I get answer A too. Both the cirriculum and Schweser say you use the bond with the higher duration, but like the question I think it’s relative to which bond you are looking at. If you are looking at how much the New Zealand bond has to move to make up the breakeven difference why would you calculate it against the Australian bond duration?
right guys. it’s A. The current yield advantage to the Australian Bond is 7.65 – 6.85 = 0.8% or 80 bp. Since the target holding period is 6 months, this represents 40 bp over the investment horizon. Next, we calculate the required change for each bond: AU = (-0.40% / -6.5) = 0.06% ==> The yield would need to increase by 6 bp (for the decrease in price, i.e., capital loss, to completely wipe out its yield advantage). NZ = (0.40% / -5.3) = -0.08% ==> The yield would need to decrease by 8 bp. In either case, the yield advantage is offset by the spread widening.
lolly Wrote: ------------------------------------------------------- > In either case, the yield advantage is offset by > the spread widening. Maybe this is the point they wanted to illustrate. Either way, I think it will just come down to rtfq. Still, the concept of breakeven spread analysis should look at it from the perspective of the higher duration bond because that’s the most conservative view, right?
Just got to this section. Thanks for the example lolly.
But if you are comparing two bonds in two different countries where yields are independent of each other, why would you use the duration on the foreign bond just because it has a higher duration? I don’t mean to be a pain in the @ss about this, I just don’t truly understand why you would use the duration on the bond you are trying to calculate this on, no matter if the duration is higher or not.
Yup, this is gonna be a fun exam! But seriously, I guess it only makes sense to figure out how much the spread must widen, per the higher duration bond, to eliminate the yield advantage of whichever bond has that higher yield. Is that a clean and simple catchall way of looking at it?
A. Australian bond yield must increase 40bp/6.5 = 6.15 (or 6 bp every 6 months) and NZ bond yield must reduce 40bp / 5.3 = 7.55 bp (or approx 8 bp) every 6 months to completely wipe out the yield advantage of Australian bond.