Financial Education

In Technical Analysis Explained, Martin Pring notes that since there are three major financial markets (stocks, bonds and commodities) and each has two turning points in a given cycle, there are six turning points in each cycle. He calls these turning points the six stages and uses them as a reference point for identifying the current phase of the business cycle and by extension the next likely turning point.

Stage 1: Slowing growth rates or early recession. Interest rates start to fall and bonds rally.

Stage 2: Business cycle trough. Stocks begin to rally.

Stage 3: Late recession and early recovery. Commodities begin to rally.

Stage 4: Early recovery. Interest rates trough and bonds peak.

Stage 5: Cycle peak. Stocks peak.

Stage 6: Slowing growth, commodities peak.

International bond managers can seek excess return from a variety of sources:

1. Bond market selection - choosing the best country in which to invest
2. Currency selection - deciding whether to hedge or retain currency risk
3. Duration/yield curve management - getting the most favorable returns within the selected market
4. Sector selection - choosing among government, corporate, local currency or dollar-denominated bonds
5. Issuer credit analysis - being able to identify improvement or deterioration in advance of changes in rating
6. Benchmark mismatches - investing in markets that are not included in the benchmark index

Changes in interest rates affect both the reinvestment rate earned on portfolio income (directly) and the value of the portfolio (inversely.) An immunization strategy is designed to lock in total return over a specified time horizon by creating a portfolio in which the two total return factors exactly offset each other.

To immunize a portfolio over a single period, the portfolio must have duration equal to the investment horizon and an initial present value of cash flows equal to the present value of the future liability.

Since yield changes over time will result in duration changes other than those caused solely by the passage of time, it is necessary to periodically rebalance an immunized portfolio. This must be done only if the benefits outweigh the costs. Some transaction costs must be borne in order to avoid duration mismatch, but some duration mismatch is needed to avoid transaction costs.

Typically the rebalancing will restore the dollar duration equivalency to the time horizon. Dollar duration is the product of Duration X Portfolio Value X 0.01.

To rebalance the dollar duration requires three steps:

1. Calculate present dollar duration based on the prevailing yield curve and time to maturity
2. Calculate the rebalancing ratio by dividing the original dollar duration by the new dollar duration. This can be expressed as the percentage change for each position by subtracting one and converting the result into percentage terms.
3. The new market value of the portfolio multiplied by the percentage change is the amount of cash that will be needed for rebalancing.

Call based securities markets attempt to gather all the bids and asks for a security at a specific time, with the intent being to price a trade that will match the quantity demanded with the quantity supplied.

Many markets use a call system to set the opening price for securities. The opening price then reflects all the buy and sell orders placed since the previous close.

For individuals drawing on retirement funds, a 4% withdrawal rate is generally recommended to result in only a small chance of the portfolio running out of money. In the October 2007 Journal of Financial Planning Spitzer, Strieter and Singh simulate thousands of 30-year periods to assess the overall probability of running out of funds.

They find that a standard 50/50 split between stocks and bonds can allow for a 4.4% withdrawal rate with just a 10% chance of depleting funds. Withdrawal rates of up to 6% can be supported with stock allocations of 75% or more.

There are three primary types of credit risk:

• Default risk is the chance the issuer will fail to meet its obligations
• Credit spread risk is the chance the spread between the risky bond and risk-free securities will vary after purchase
• Downgrade risk is the chance a rating agency will lower its rating on the issuer

These risks can be hedged using option contracts.

A binary credit option pays off only if a specified negative event occurs. These can be used to hedge default risk or downgrade risk.

Credit spread options pay off based on the spread over a benchmark rate. They can be used to hedge credit spread risk.

Using leverage magnifies the return in a portfolio. If a portfolio can earn 7% and can borrow funds at 5%, the additional 2% accrues to the fund investors. Instead of earning 7,000 on a 100,000 investment, the manager borrows an additional 100,000 and can earn 14,000, but must pay 5,000 in interest. The 9,000 remaining equates to a 9% return for the investors.

If the fund fails to earn the cost of borrowing, the leverage will work in the opposite direction as a drag on returns.

Given the liquidity of certain types of bonds, many managers seeking leverage make use of repurchase agreements (repos). These are agreements to sell a set of securities and to buy them back at a later agreed-upon date and price. The price difference is called the repo interest.

Repos offer the borrower lower rates (due to the liquid collateral) and the lender higher returns than Treasury bonds. Several factors contribute to the final repo rate that will be charged:

• Quality of collateral - higher quality bonds result in a lower repo rate
• Term of the repo - a longer term equates to a higher repo rate
• Delivery requirement - if the lender takes physical delivery of the collateral there is no default risk and the repo rate will be lower. Escrow accounts will reduce the rate to a lesser extent relative to no delivery.
• Availability of the collateral - if the bonds being offered as collateral are difficult to buy, the lender may accept a lower rate for the repo
• Prevailing interest rates - repos are generally tied to short-term interest rates
• Seasonal factors - certain market participants may have seasonal factors that affect their supply and demand for capital

Secondary markets are those in which securities that have already been issued trade. Transactions occur between investors, and the proceeds do not affect the issuer. Instead, one investor gives another investor cash in exchange for the securities.

Secondary markets provide liquidity to the investors who initially buy the securities. Investors value liquidity because changes in their circumstances may require them to sell the security in order to use the cash for other purposes. By having a liquid secondary market, investors are willing to pay more (accept a lower return) when buying primary issues. This helps issuers raise money at more favorable rates.

Secondary markets also offer issuers price discovery - new issues can be priced according to the value of other similar securities.

The difference between the cash price of a bond and the futures price is called its basis. Basis risk is the chance that basis will change between unpredictably between the time the hedge is initiated and the time the hedge is lifted.

If the bond underlying the futures contract differs from the portfolio bond (a situation known as a cross hedge) the basis risk can be substantial. In essence the hedge substitutes basis risk for price risk.

The hedge ratio equals the factor exposure on the portfolio divided by the factor exposure on the hedging instrument.

If the factor is limited to interest rate exposure and one assumes a fixed yield spread between the bond being hedged and the cheapest-to-deliver (CTD) bond on the futures contract, the hedge ratio equals the product of the duration and price of the hedged bond, divided by the product of the duration and price of the CTD bond.

A total return analysis is a tool used to determine how a particular trade will affect the return in a portfolio. Given a specific interest rate forecast, the manager can determine how the transaction’s reaction will affect the return and risk of the overall portfolio.

Since any single interest rate forecast is subject to considerable error, most managers will not rely on one. Scenario analysis runs several total return analyses using a wide range of reasonable assumptions. Benefits of scenario analysis include:

• The ability to assess the distribution of possible returns
• The ability to reverse the calculation and find the range of interest rate movements that would result in the desired outcome
• The ability to evaluate components of total return
• Applicability to entire trading strategies rather than merely single trades