The guideline answer mentions that the plan wants to shorten the effective duration of it FI portfolio and would prefer to increase the convexity at the same time. I know the interest rate is going down, so we want to shorten the duration. But where do we know the plan prefer to increase the convexity? Is that related to the Yield vs. Maturity chart? Thanks
I think you might have misread the question. It states he believes interest rates will rise in the near term and wants to protect the value of the portfolio.
If the yield curve is moving up you want more convexity and reduced duration. To gain convexity you must buy both call and put options. To reduce duration you must buy put options.
So he should buy call and puts (to increase convexity), but buy more puts than calls (to reduce duration).
#Voyager3, thanks for the input!
Can you elaborate it more why the yield curve is moving up we want more convexity and reduce the duration?
I think I am little bit confused here,
I understand the we want the decreased duration as the interest rate will rise and price is down. Is that because yield curve is flatten so we want to have more convexity? Also, does yield curve move up mean interest go down? Do I miss anything here?
Yes, an increase in the yield curve means interest rates are moving up. This means the curve is steepening. There’s a lot of interchangeable language in fixed income so you have to understand the basics.
Yield curve up = interest rates rising.
Yield curve down = interest rates falling
If interest rates are moving up this means bond prices are going down. To lessen the impact of the loss of your portfolio you would shorten the duration of the bonds you own. Shorter duration = less sensitivity to interest rate changes.
Convexity is a phenomenon that causes your bond to decrease LESS in value when rates rise, and increase MORE in value when rates drop. There are several ways to add convexity; one of which to to buy options on bonds.
On a side note, are you a level 1 candidate? A little aggressive to be tackling level 3 questions at this stage!
I have an inquiry regarding the same question.
The manager expects interest rates to increase…shouldn’t he _ only _ be buying puts? Buying puts would increase convexity (good thing when int.rates increase) and decrease duration (good thing when int.rates increase). Yet, the guidelines answer provided is to buy call options and buy put option but buying more put options than call options.
Why would you buy calls if you think int.rates increase? Am I missing something here.
That’s a good point, but it wasn’t an option in the question. I suppose because it would both add additional convexity and provide a hedge if rates were to decrease instead?
If you buy puts and don’t buy calls, then haven’t you, in fact, bought more puts than calls?
But the answer says he does, in fact, buy both calls and puts?
I think the goal of the question/guideline answer was to make a point on how calls and puts may be used to change both convexity and duration of the portfolio.
You’re absolutely right. Good point.
It’s a matter of how much additional convexity you want. Buy zero calls and one put, you shorten your duration and pick up a smidgeon of convexity. Buy 100 calls and 101 puts and you shorten your duration by the same amount as before, but you pick up a ton of convexity.
Thanks Bill, makes sense. So in essence buying the calls along with the puts allows you to control how much you shorten duration while gaining additional convexity.
If you just buy 100 puts and no calls, you could theoretically pick up the desired convexity but reduce your duration more than you wanted to.
Bingo!
(Every once in a while I actually understand this stuff.
And it’s scary!)