INTERNATIONAL INVESTMENT MANAGEMENT BOOK SUMMARY
Table of Contents
Week 6 – Bonds II: International Aspects and Interest Rate Risk & Derivatives I: Futures and
Forwards..........................................................................................................................................2
Chapter 15.6: Forward Rates as Forward Contracts.......................................................................................2
Chapter 16.1: Interest Rate Risk.....................................................................................................................2
Chapter 22.1: The Futures Contract...............................................................................................................4
Chapter 22.2: Trading Mechanics...................................................................................................................4
Chapter 22.3: Futures Markets Strategies......................................................................................................5
Chapter 22.4: Futures Prices...........................................................................................................................6
Chapter 22.5: Futures Prices versus Expected Spot Prices.............................................................................7
Chapter 25.1: Global Markets for Equities.....................................................................................................8
Chapter 25.2: Exchange Rate Risk and International Diversification.............................................................8
Chapter 25.3: Political Risk.............................................................................................................................8
Week 7 – Derivatives II: Options.......................................................................................................9
Chapter 20.1: The Option Contract................................................................................................................9
Chapter 20.2: Values of Options at Expiration.............................................................................................10
Chapter 20.3: Option Strategies...................................................................................................................10
Chapter 20.4: The Put-Call Parity..................................................................................................................13
Chapter 20.5: Option-Like Securities............................................................................................................13
Chapter 20.6: Financial Engineering.............................................................................................................14
Chapter 20.7: Exotic Options........................................................................................................................15
Chapter 21.1: Option Valuation: Introduction..............................................................................................16
Chapter 21.2: Restrictions on Option Values...............................................................................................16
Chapter 21.3: Binomial Option Pricing.........................................................................................................17
Chapter 21.4: Black-Scholes Option Valuation.............................................................................................17
Week 8 – Market efficiency: Efficient Market Hypothesis and Behavioral Finance.........................19
Chapter 11.1: Random Walks and Efficient Markets....................................................................................19
Chapter 11.2: Implications of the EMH........................................................................................................19
Chapter 11.3: Event Studies.........................................................................................................................20
Chapter 11.4: Are Markets Efficient?...........................................................................................................21
Chapter 11.5: Mutual Fund and Analyst Performance.................................................................................21
Chapter 12.1: The Behavioral Critique.........................................................................................................22
,Week 6 – Bonds II: International Aspects and Interest Rate
Risk & Derivatives I: Futures and Forwards
Chapter 15.6: Forward Rates as Forward Contracts
We can derive forward rates with the following formula:
¿
In general, they will not equal the eventually realized short rate, or even today’s expectation of what
that short rate will be. To construct the synthetic forward loan, you sell (1 + f2) 2-year zeros for every
1-year zero that you buy. This makes your initial cash flow zero because the prices of the 1- and 2-
year zeros differ by the multiple (1 + f2).
Chapter 16.1: Interest Rate Risk
The sensitivity of bond prices to changes in market interest rates is obviously of great concern to
investors. Bond prices decrease when yields rise and the price curve is convex, meaning that
decreases in yields have bigger impacts on price than increases in yields of equal magnitude. We
summarize these observations in the following two proportions:
1. Bond prices and yields are inversely related: as yields increase, bond prices fall; as yields fall,
bond prices rise.
2. An increase in a bond’s yield to maturity results in a smaller price change than a decrease in
yield of equal magnitude.
The figure above shows that bond B, which has a longer maturity than bond A, exhibits greater
sensitivity to interest rate changes, thus:
3. Prices of long-term bonds tend to be more sensitive to interest rate changes than prices of
short-term bonds.
4. The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity
increases. In other words, interest rate risk is less than proportional to bond maturity.
Bond B and C, which are alike in all respects except for coupon rate, illustrate that the lower-coupon
bond exhibits greater sensitivity to changes in interest rates, thus:
5. Interest rate risk is inversely related to the bond’s coupon rate. Prices of low-coupon bonds
are more sensitive to changes in interest rates than prices of high-coupon bonds.
Finally, bonds C and D are identical except for the yield to maturity at which the bonds currently sell,
thus our final property will be:
6. The sensitivity of a bond’s price to a change in its yields is inversely related to the yield to
maturity at which the bond currently is selling.
Maturity is a major determinant of interest rate risk. However, maturity alone Is not sufficient to
measure interest rate sensitivity. The greater sensitivity of zero-coupon bonds suggests that in some
sense they must represent a longer-term investment than an equal-time-to-maturity coupon bond.
, The effective maturity of the bond is an average of the maturities of all the cash flows. The zero-
coupon bond makes only one payment at maturity, therefore its maturity is well-defined.
Higher-coupon-rate bonds have a higher fraction of value tied to coupons rather than final payment
of par value. And thus, the portfolio of payments is more heavily weighted toward the earlier, short-
term maturity payments, which gives it lower effective maturity.
A higher yield reduces the present value of all of the bond’s payments, but more so for more-distant
payments. Therefore, at a higher yield, a higher proportion of the bond’s value id due to its earlier
payments.
Macaulay’s duration equals the weighted average of the times to each coupon or principal payment,
with weights related to the ‘importance’ of that payment to the value of the bond. Specifically, the
weight applied to each payment time is the proportion of the total value of the bond accounted for
by that payment, that is, the present value of the payment divided by the bond price.
We define the weight, wt, associated with the cash flow made at time t as:
w t=CF t /¿ ¿
Using these values to calculate the weighted average of the times until the receipt of each of the
bond’s payments, we obtain Macaulay’s duration formula.
T
D=∑ t × wt
t =1
Duration is a key concept in fixed-income portfolio management for at least three reasons:
1. It is a simple summary statistic of the effective maturity of the portfolio.
2. It turns out to be an essential tool in immunizing portfolios from interest rate risk.
3. Duration is a measure of the interest rate sensitivity of a portfolio.
It can be shown that when interest rates change, the proportional change in a bond’s price can be
related to the change in yield to maturity according to the rule:
ΔP
P
=−D ×
1+ y [
Δ ( 1+ y )
]
The proportional price change equals the proportional change in 1 plus the bond’s yield times the
bond’s duration. You can rewrite the function above to:
ΔP
=−D × Δ y
P
Modified duration is a natural measure of the bond’s exposure to changes in interest rates.
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