Question

2. Active bond management is based on the belief that the bond market is not perfectly efficient and potential gains may be obtained by buying (selling) the underpriced (overpriced) bonds. To identify mispriced bonds, bond managers need to have superior information about future interest rates or default probability. In the class, we discussed several commonly used trading strategies, including the inter-market spread Swap, the rate anticipation swap, and the riding the yield curve. Explain the potential risks of these strategies. (20 points)

Answer 1

Active bond management does work to at certain extent since any financial instrument in real world is not perfectly priced so some fixed income managers are able to extract profits out of these types of strategies however these strategies are not free from risk associated with it.

· The mispricing of bond is based on the idea of the law of one price that asset producing similar cash flows should have the similar price but for a fixed income manager how can somebody determine with full surety that the probability of future cash flows occurring are also same, it might happen that manager thinks that one asset is undervalued but is low in price because of the default probability.

· Inter-market swap and interest rate swap are based on the idea that different market have different borrowing rates and different level of risk. Now suppose that a manager is able to find a profitable opportunity for inter-market swap but what happens if the other party in other market defaults on its obligation, your investment will not give you the desired result so there is counterparty default risk associated with these strategies.

· Riding the yield curve is a strategy in which you buy the bond which have higher maturity than the investor investment horizon. Let’s say an individual investment horizon is 5 years so you buy the bond with a maturity of 7 years or 10 years and sell the bond at the end of 5 years in anticipation of capital gain, now lets suppose that you are able to find such a bond but what if there is not enough liquidity in the market to sell the bond then in that case you would lose the benefit.