Pimco Fi Risk

FOR EDUCATIONAL USE ONLY
PIMCO
Understanding Derivatives and
Managing Risk in a Bond Portfolio
This presentation is distributed for educational purposes only. Information contained herein has been obtained from
sources believed to be reliable, but not guaranteed. No part of this publication may be reproduced in any form, or
referred to in any other publication, without express written permission. PIMCO Australia Pty Ltd, Level 19, 363
George St., Sydney, NSW 2000, ABN: 54 084 280 508, AFS License 246862. Copyright PIMCO 2004.
The Top 10 Reasons Why Bonds Are Fun
10) There are lots of them, in all shapes and sizes
$45 trillion, in all, worldwide
9) They are ahead of equities in the capital structure, which
can be a very good thing
8) We get to use bond math to figure out how they work
(even though we actually just look them up on Bloomberg)
7) There's a mysterious inverse relationship between yield and
price... understanding this can help you gain the trust and
respect of friends and family
6) We get to make up terms like duration and convexity,
back them with fancy formulas, and then act like they're
the greatest discovery on earth
The Top 10 Reasons Why Bonds Are Fun
(Continued)
5) Who else has yield curves, and can talk about barbells,
bullets and ladders?
4) Corporates spreads can change often and sometimes
significantly, for reasons other than simple default risk
3) Mortgages have embedded options, which makes them a
fascinating sector and a natural draw for MIT grads
2) Benchmarks actually matter
1) You get to build portfolios and, unlike equity managers,
manage risk
Agenda
Module 1: Understanding Fixed Income Risks
Module 2: Understanding Derivatives and Their
Uses in Modern Bond Portfolios
Module 3: Balancing Risks Across Instruments
The Risks of Bond Ownership
Bond holders are paid, in the form of coupon and
maturity payments, to assume these risks
Rule of thumb: The greater the risk, the higher the yield
1. Interest Rate Risk
2. Volatility Risk
3. Credit Risk
4. Liquidity Risk
Measurement: Duration
Yield
Price
Yield
Price
1. Interest Rate Risk
Definition: The risk that the promised yield on a bond at
purchase will not match the market required yield at
later points in time. Interest rate risk is the primary risk
associated with Treasury securities.
SOURCE : Frank Fabozzi
Examples:
1. Measuring Interest Rate Risk:
Duration
Duration is an estimate of a security or portfolios price
sensitivity in response to changes in interest rates
Defined as net present value of weighted average cash flows
Measured in years (like average maturity)
Two rules of thumb:
- Longer the maturity, longer the duration
- Lower the coupon, longer the duration
105 +5% -1.0% 5 Years 100
95 -5% +1.0% 5 Years 100
Ending
Price
Change In
Price
Change In
Yield
Duration
Starting
Price
1. Measuring Interest Rate Risk:
Convexity
+10%
-10%
Expected
Price Change
(From Duration)
5 Years
5 Years
Duration
+11% +1% -2.0% +0.5
-9% +1% +2.0% +0.5
Actual Price
Change
Impact of
Convexity
Change In
Yield
Convexity
Duration captures the price impact of changes
in interest rates
Works well for small changes in yield
But duration itself will change with larger changes in rates
Convexity captures this impact
Measures additional price impact of changes in duration
Positive convexity can be a very good thing:
1. But Convexity Comes at a Cost
Yield Give Up
Price
Falling Rates Moderate
Change in Yields
Rising Rates
Negative Convexity
- Higher yield
- Best in stable environment
Positive Convexity
- Lower yield
- Best in volatile environment
1. Yield Curve Risk
Duration assumes rates for all
maturities will change by the
same amount (a parallel shift
in the yield curve)
Y
i
e
l
d

(
%
)
1
2
3
4
5
6
7
3m 2Y 5Y 10 30 Y Y
7
Y
i
e
l
d

(
%
)
1
2
3
4
5
6
3m 2Y 5Y 10 30 Y Y
In reality, interest rates rarely
move in a uniform fashion
Measurement: Duration
weighted maturity exposure
and curve duration
1. Measuring Yield Curve Risk:
Curve Duration
Curve Duration measures a portfolios sensitivity to changes in the
slope of the yield curve.
SOURCE: PIMCO
2-30
Difference
100 bps
2-30
Difference
200 bps
Rotation Around the 10 Year
30 2 10
Maturity (yrs)
Y
i
e
l
d

(
%
)
4.0
4.5
5.0
5.5
6.0
6.5
7.0
1. Curve Duration Example
Consider a 1% steepening in the yield curve
- +0.75% Relative Performance
- 0.75 Years Total Curve Duration
+0.25%
+0.25 Years
Benchmark
+1.0% Absolute Performance
+1.0 Years Curve Duration
Portfolio A Characteristics
SOURCE: PIMCO
4
5
6
7
3m 1Y 5Y 10Y 15Y
Australian Government 12/31/2002 New Zealand Government 12/31/2002
Australian Government 12/31/2003 New Zealand Government 12/31/2003
0
1
2
3
4
5
6
3m 1Y 5Y 10Y 15Y 30Y
U.S. Yield Curve 12/31/2002
U.S. Yield Curve 12/31/2003
1. Global Interest Rate Exposure
U.S. Treasury Yield Curves
Y
i
e
l
d

(
%
)
SOURCE: Bloomberg Financial Markets
Australia / New Zealand Yield Curves
Y
i
e
l
d

(
%
)
2. Volatility Risk
Definition: The risk that changes in interest rate levels
will materially alter the expected cash flow pattern of
a bond and change the rate at which these cash flows
can be reinvested
Example: This is most prevalent in bonds with
embedded options
Mortgage Backed Securities: The option for homeowners
to prepay their mortgage makes cash flows uncertain
Corporate Securities: The option for corporations to call
their bonds may cap price appreciation when rates fall
Measurement:
SOURCE : Frank Fabozzi
Convexity
Bull/Bear Duration
2. Embedded Options in
Fixed Income Securities
Option
Written to
Homeowner
Option
Written to
Corporate
Issuer
Mortgage
Backed
Securities
=
Callable
Corporates
=
Agency
Bond
-
Corporate
Bond
-
2. Embedded Options in
Mortgages and Corporates
P
r
i
c
e
Yield
Mortgage:
-
Straight Bond
P
r
i
c
e
Yield
=
Prepayment Option
P
r
i
c
e
Yield
Mortgage
Straight
Bond
Mortgage
P
r
i
c
e
Yield
Callable
Corporate:
-
Straight Bond
P
r
i
c
e
Yield
=
Call Option
P
r
i
c
e
Yield
Callable Corporate
Straight
Bond
Callable
2. Measuring Volatility Risk
Back to Convexity
SOURCE: Frank Fabozzi
Price
Yield
Investors are paid incremental
yield for assuming convexity risk
Callables outperform in stable
rate environments, while non-
callables win in volatile rate
environments
Callable Bond
Outperforms
Non-Callable Bond
Outperforms
Bonds with embedded options
have negative convexity
Callable Bond
Non-callable bonds exhibit
positive convexity
Non-Callable Bond
2. Another Way to Measure Volatility
Risk: Bull and Bear Duration
Convexity estimates change in duration due to changes
in interest rates
Assumes symmetrical changes as rates move up/down
Bull and Bear Duration measures specific duration
changes if rates move up/down 50 bps
Captures asymmetry of embedded options
4.9 Yrs
4.1 Yrs
-0.3 Yrs
+0.3 Yrs
Bull Mkt
Duration
4.2 Yrs
4.8 Yrs
Revised Duration
Bull Mkt Bear Mkt
+0.4 Yrs 4.5 Years
--0.4 Yrs 4.5 Years
Bear Mkt
Duration
Original
Duration
2. Mortgages Spreads (vs. Treasuries)
Compensate for Volatility Risk
0
50
100
150
200
250
300
98 99 00 01 02 03
Fixed Rate MBS Spread Level
S
p
r
e
a
d

L
e
v
e
l

(
b
p
s
)
2. Mortgage Spread Duration Measures
Mortgage Spread (Volatility) Risk
MBS spread duration captures a portfolios price
sensitivity to changes in MBS spreads. MBS spread
levels vary with interest rate volatility
Example: Assume a 0.50% decrease in MBS Spreads:
- +0.25% Relative Performance Impact
-
0.75%
1.5 Years
Benchmark
0.5 Years MBS Spread Duration Delta
+1.0% Absolute Performance Impact
2.0 Years MBS Spread Duration
Portfolio A Characteristic
3. Credit Risk
Definition: The risk that a promised yield on a corporate
bond will fail to compensate the investor for bearing the
risk of default
Spread risk
Downgrade risk
Default risk
Example: Fixed income securities other than those
guaranteed by the U.S. Government carry some
amount of credit risk
Measurement: Credit risk must be evaluated at the
individual security and portfolio level. Two key metrics:
Quality rating
Credit spread duration
3. Types of Credit Risk
SOURCE: Moodys and Citigroup Yield Book
B
AA
AAA
BAA
A
Quality
CAA
and Below
BA
562.7
65.6
37.6
168.8
92.2
Average Spreads
1206.0
341.7
1992-2003 (bps)
Min: 338.4 Max: 1082.5
Range:
Min: 48.5 Max: 136.1
Range:
Min: 37.1 Max: 119.2
Range:
Min: 88.6 Max: 373.3
Range:
Min: 56.5 Max: 184.9
Range:
Spread Risk
Min: 561.6 Max: 2033.9
Range:
Min: 166.3 Max: 734.3
Range:
1992-2003
Spreads to Treasuries (bps)
3.3
7.2
N/A
10.6
4.7
Downgrade Risk
7.2
4.7
Down/Up Ratio
2002
6.9
0.0
0.0
1.0
0.7
Default Risk
36.8
2.1
Default Rate
1994-2002 (%)
1472.3
568.0
284.7
128.4
87.6
82.1
744.1
3. Corporate Bonds:
A More Cynical View
Corporate
Bond
Equity
Holders
Put Option
Risk Free
Bond
=
-
In other words:
If prosperity, equity holders get upside
If bankruptcy, equity holders put worthless assets to bondholders
Corporate spreads are a function of this put
3. Volatility is Increasingly Important
in Assessing Spread Risk
Corporate spreads are based on issuers ability to repay
Issuers ability to repay influenced by:
Financial strength
Capable management (and incentives)
Access to capital markets
Rating agency views and actions
Macroeconomic forces
Event risk
All of which are influenced by volatility
Higher volatility = greater risk = wider spreads
3. Compensation for Credit Risk
Credit Spreads Relative to 10-Year Treasury
S
p
r
e
a
d

L
e
v
e
l

(
b
p
s
)
-200
0
200
400
600
800
1000
1200
91 92 93 94 95 96 97 98 99 00 01 02 03 04
A Rated Spread BBB Rated BB Rated B Rated
3. Measuring Credit Risk:
Corporate Spread Duration
Corporate spread duration captures a portfolios price
sensitivity to changes in credit spreads
Example: Assume a 1.0% increase in credit spreads
- -0.75% Relative Performance Impact
-
-2.25%
2.25 Years
Benchmark
+0.75% Credit Spread Duration Delta
-3.0% Absolute Performance Impact
3.0 Years Corporate Spread Duration
Portfolio A Characteristic
4. Liquidity Risk
Definition: Liquidity risk is the risk that the investor
will have to sell a bond below its true value where
the true value is indicated by a recent transaction
Example: Periodic freezing of corporate market
during periods of financial distress
Measurement: Bid-Ask Spread
4. Measuring Liquidity Exposure:
Bid-Ask Spread Levels
bonds bonds
Finance
Corporates Aa/Aaa
Bid-Ask spread levels vary by sector of the bond market
Typical Bid-Ask Spreads
of Distress
Bid-Ask Spreads in Times
They also fluctuate widely in times of distress in fixed
income markets
Bid-Ask Spreads
B
i
d
-
A
s
k

S
p
r
e
a
d

(
%

o
f

P
r
i
c
e
)
0
1
2
3
4
5
6
Treasury Bill On-the-run
notes and
Off-the-run
notes and
A Rated
Corporates
B Rated
Industrial
Fixed Rate
Generic MBS
Municipals
(long),
Rated
A Summary of Fixed Income Risks
Depth of market for
a security
BidAsk Spread Liquidity Risk
Price risk due to
changes in credit
worthiness
Credit Spread
Duration
Quality
Credit Risk
Price impact due to a
change in rates and
security optionality
Convexity
Bull/Bear Duration
MBS Spread Duration
Volatility
(Prepayment/Call)
Risk
Price impact due to
changes in the level
or shape of the yield
curve
Duration
Convexity
Curve Duration
Interest Rate Risk
Factors Evaluated Measurement Risk
Managing Risks Balance is Critical
Issue
Selection
Sector
Emphasis
Maturity
Mix
Duration
Portfolio
Strategy
Relative Value
Expected Volatility
Credit Trends
Fed Policy
Inflation
Macro Trends
General Rate Views
Key Drivers
Risk Measures
Convexity
Bull/Bear Duration
Spread Duration
Quality Ratings
Liquidity
Duration
Convexity
Curve Duration
Trade-Offs
Yield Pick-Up
vs.
Price Risk
Agenda
De-Mystifying Derivatives
What is a derivative?
A financial instrument that derives its value from
movements in an underlying security
Financial derivatives include:
Forwards
Futures
Swaps
Options
CMOs
IOs/POs
Structured Notes
Advantages and Disadvantages
of Derivatives
Advantages:
Large market size
Customizable
Disadvantages:
Instrument structure and risk measurement
can be complex, less intuitive
Concerns:
Leverage
Derivatives can replicate the
most common physical
securities of the bond market
such as Treasuries, mortgages,
and corporate bonds
Derivatives can facilitate more
precise duration, curve, and
spread risk management
Using Derivatives in a
Fixed Income Portfolio
Cash Vehicles
Treasuries
Mortgages
Corporates
Derivative Instruments
Treasury
Futures
Options/
Forwards
Interest
Rate and
Credit
Swaps
Derivative and Cash
Risk Exposures are Similar
Credit Corporates Swaps
Mortgages Options
Cash Instruments Derivative Instruments
Treasuries Futures
Volatility
Risks
Duration
Forward Contracts
Forward Contracts: An agreement between a buyer
and seller to purchase (or sell) a specific good or
asset at a specific date for a specific price
Each party gains an asset and a liability
The agreement is an obligation
The customized nature of forward contracts makes
them less liquid
This limitation led to the development of a specialized form
of the forward contract the futures contract
SOURCE: Robert Kolb
Futures Contracts
Futures Contracts: A type of forward contract with highly
standardized and closely specified contract terms
As in all forward contracts, a futures contract calls for
the exchange of a good at a future date for cash
The owner of the future contract is said to be Long the good
or financial instrument
The seller of the future contract is said to be Short the good
or financial instrument
SOURCE: Robert Kolb
Futures Contracts
Features of futures contracts
Exchange traded
Highly standardized terms (good, quantity,
delivery date, and delivery mechanism)
Liquid
Margin requirements
Daily resettlement
Performance guaranteed by a clearinghouse,
minimizing credit/counterparty risk
Regulated by government agencies
SOURCE: Robert Kolb
How is the Price of a Futures
Contract Determined?
The price of a futures contract reflects:
Spot price: The current price of the asset
Cost of carry:
-The cost of lost investment income
-The cost of owning the good until delivery (storage
expense)
Benefit of carry:
-Foregone benefit (if any) of holding the physical
asset/good
Future Price Cost of Carry Spot Price =
-
Benefit of
Carry
+
A Hypothetical Futures Example:
Two Ways to Gain Auto Exposure
Futures Example (Wool)
Two Ways to Gain Wool Exposure
Net Cost
$0)
($243)
($1,025)
$0) $(18,750)
($20,018) $0)
($20,018) ($20,018)
Option 1:
Buy the Wool
and Store It
Option 2:
Buy the Futures
Contract
Costs:
Wool Spot Price
(2,500 kg * $7.50 per kg)
Cost of Carry
Lost Investment Income
$18,750 x (5.0% 4)
Storage Cost
2,500 kg x $0.41/kg
Payment of One Futures Contract
in 3 Months (2,500 x $8.01/kg)
Future
Price
Cost of
Carry
Spot
Price
=
-
Benefit of
Carry
+
Typical Financial Futures Contracts
Financial futures contract: Agreements to purchase
or deliver a bond in the future (bond futures) or settle
market value in cash (interest-rate futures) in the future
Bond Futures
Allow for a bond to be bought/sold in the future
Typical instruments: 2-year, 5-year, 10-year, 30-year Futures
Example: 10-year Treasury Future
- The buyer of the contract agrees to receive a Treasury Note by paying
a specific price on a future date
Interest Rate Futures
Settled in cash
Typically short-term instruments, based on an index rate
Example: Eurodollar Futures
Financial Futures Example
An investor would like to gain exposure to the 10-Year
Treasury Note for the next three months
The 10-Year Treasury trades at par, yields 5%
(Spot price = $100)
Cost of carry:
Market rate rate of interest: 2.0%
3 Month Interest expense: $0.50 = (2% 4) x $100
Benefit of carry:
Foregone coupon payment (3 months): $1.25 = (5% 4) x 100
Futures Price
$99.25
Interest
$0.50
Spot Price
$100
=
-
Coupon Give
Up $1.25
+
$100.00) Cash Balance
1.25% Return
8 Years Duration
Buy Bond
Total
Receive Maturity
Payment
Accrued Coupon
100 x (1+5% 4)
Buy Bond
Action
$101.25)
$1.25)
($100.00)
$100.00)
Cash Flow
Two Ways to Gain Treasury Market
Exposure
Financial Futures Example (Continued)
$(99.25) Pay Futures Liability
1.25% Return
8 Years Duration
$1$100.00
)00
Cash Balance
Long Futures
Total
Receive Bond
Invest at Risk Free Rate
100 x (1+2% 4)
Long Futures
Action
$101.25
$0.50
-
$100.00
Cash Flow
Interest-Rate Futures
Example: Eurodollar Futures
Eurodollar: Dollar denominated assets held outside of the U.S.
Very liquid
Contract indexed to 3-month London Inter Bank Offer Rate (LIBOR)
Duration is three months (0.25 Years)
Settled in cash
Contract size is $1,000,000
- As LIBOR rate moves by 1 bp, contract value changes by:
$1,000,000 * .01% * .25 yrs = $25
1-year exposure can be achieved in different ways:
1 Year
Y
i
e
l
d
Time
Sep Dec Mar Jun
1.00 Year
Duration
$1,000,000
Par/Notional
1 Year
Total Duration
1 1-Year LIBOR
# Required Instrument
Using Eurodollar Futures
3 Month
3 Month
3 Month
3 Month
0.25 Year $1,000,000 1 Year 4 Eurodollar Future
Eurodollar Futures: Means to Precisely
Target Short Maturity Rates
Eurodollar futures provide
means to target specific
portions of the short
maturity yield curve
Example:
In June 2004, market
participants anticipated
Federal Reserve tightening
Two ways to gain 1 Year
of duration exposure
- Buy 1 Year LIBOR
- Buy 4 Eurodollar contracts
Use of Eurodollar futures
targets specific 3 month rates
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Spot 1
Year
Libor
Sep-04 Dec-04 Mar-05 Jun-05
06/30/2004 09/30/2004
LIBOR Yields
P
e
r
c
e
n
t

(
%
)
Hypothetical example for illustrative purposes only.
The above chart is a representation of a sample trade and no guarantee is being made that any account will have the same structure or that similar results will be achieved.
4
1
# Required
0.25 Year
1.00 Year
Duration
65 bps
50 bps
Gain for Period
1 Year Eurodollar Future
1 Year 1-Year LIBOR
Total Duration Instrument
Applications for Futures and Forwards
Substitution
Hedging
Managing duration and curve exposure
Broker
Deposit
(2%)
Amount
of Cash
Investment
Buy
Cash-
Equivalent
Securities
(98%)
Bond
Futures
Coupon
Bonds
Buy
Bonds
Directly
Futures may be used as
substitutes for physical
securities
Futures may be more
attractively priced
Futures may have more
attractive risk characteristics
Futures facilitate cash backing
strategies
Remaining cash available
to be invested in higher-
yielding short-term
securities
Term premium
Credit premium
Volatility premium
Liquidity premium
Futures Applications: Substitution
Futures Applications: Hedging
Duration Contribution Exposure Duration Instrument
5.25 Years
1.00 Years
0.75 Years
3.50 Years
$100 MM) 5.25 Years Total
4.00 Years
3.00 Years
7.00 Years
$25 MM) Corporate Note
$25 MM) Mortgage Pass Through
$50 MM) Treasury Note
Benchmark Duration: 4.50 Years
Current Portfolio Duration: 5.25 Years
Reasons for using the futures market:
Liquidity
Ability to target specific risk exposures
4.25 Years New Portfolio Duration
(1.00 Year) ($12.5 MM) 8.00 Years Sell 10-Year Futures
Accounting and Economic Leverage
Accounting leverage exists whenever assets > net worth
Accounting leverage occurs in any portfolio with unsettled trades
Economic leverage exists whenever portfolios expected
volatility exceeds that of a reference point
Several Ways to Achieve
Duration Target
Total
Desired
Duration
=
Assets:
Cash:
Liabilities:
Ten-Year
Note
8 Year
Duration
$100
$0
$0
$100 Net Assets:
=
Ten-Year
Futures
8 Year
Duration
$100
$100
($100)
$100
Five-Year
Futures
4Yr
Duration
4Yr
Duration
$200
$100
($200)
$100
Leverage
10 Yr Ftr
8 Year
Duration
Assets:
Cash:
Liabilities:
$200
$0
($100)
$100
?
5 Yr Nt
4 Yr
Duration
Net Assets:
Targeting Specific Duration
and Curve Structure with Futures
Y
i
e
l
d
3 Mos 5 Yr 10 Yr 30 Yr
Maturity
Two 5-year futures
One 10-year Note or Futures
8 year
duration
8 year
duration
Using Futures:
Managing Duration and Yield Curve
12/31/00
12/31/01
0
U.S. Treasury Yield Curve
1
2
3
4
5
6
7
3m 2Y 5Y 10 15 30 Y Y Y
Y
i
e
l
d

(
%
)
Futures may offer a way to manage duration and yield
curve risks that the cash market may not provide
Two 5-year futures
8 year
duration
One 10-year Note or Futures
8 year
duration
Risks of Forward and Future Contracts
Interest rate risk: Similar to risk of physical
bond ownership
Convexity: Delivery option with futures alters the
convexity profile of the portfolio
Credit/counterparty risk: Depends on counterparty
For futures contract: Exchange acts as counterparty credit risk
is credit risk associated with exchange
Liquidity risk: Depends on contract type
Forward contracts: Unique contract nature can affect liquidity
Futures contracts: Exchange traded nature facilitates liquidity
Summary
Futures contracts are a form of forward contracts
Both of these instruments provide an efficient means of gaining
or reducing interest rate and yield curve exposure
Futures contracts offer many interesting benefits
Very liquid securities with minimal credit risk
Futures contracts are often more flexible than cash instruments
Futures can be used as:
- A substitute for physical securities
- A hedging tool
- A means to best manage duration and yield curve exposure
Futures contracts allow for the possibility of leverage
Leverage can be identified in the form of increased duration
Swaps
A swap is an agreement between two or more parties to
exchange sets of cash flows over a set period of time
Example: Party A agrees to pay a fixed rate of interest
on $1 mm each year for four years to party B. In return
party B pays a floating rate of interest on $1 mm each
year for four years
Counterparties: The parties that agree to the swap
The most common swaps include:
Interest Rate Swaps: exchange fixed for floating rates
Total Return Swaps: exchange floating rate for index return
Credit Default Swaps: exchange floating rate for default protection
SOURCE: Robert Kolb
0
20
40
60
80
100
120
98 99 00 01 02 03
Interest Rate Swaps Have Gained
Importance in Fixed Income Markets
Interest rate swaps
have increasingly
replaced U.S.
Treasuries as the
primary reference
for interest rates
Like other derivatives,
interest rate swap
volume has experienced
significant growth
SOURCE: BIS, ISDA
T
r
i
l
l
i
o
n
s

(
$
)
Interest Rate Swaps Outstanding
Interest Rate Swaps Are
Very Similar to Owning a Bond
Bond:
Party A Party B
Maturity Payment
Fixed Coupon
Payment
Principal Payment
Party A Party B
Fixed Payment
Floating Rate
Swap:
Owning a physical (cash)
bond is equivalent to
being short a floating
rate note
Lender exchanges a
principal payment for
a series of fixed coupon
payments
Lender forgoes the
opportunity to invest in
cash at a floating, short
term rate
This is equivalent to
paying a floating rate
Swaps provide similar
interest rate exposure
?
?
?
?
?
?
?
?
Interest Rate Swaps Are Similar to
Owning Fixed and Floating Bonds
Receiving fixed swap
payments provides exposure
similar to purchasing a fixed
coupon bond
Paying floating rate swap
payments equivalent to
issuing a floating rate bond
A swap simplifies this
transaction
Notional amounts not exchanged
Yr 0
Yr 1 Yr 2 Yr 3 Yr 4
Yr 0
Yr 1
Yr 2
Yr 3
Yr 4
Interest Rate Swap Payment Conventions
Fixed
Floating
Gross settlement payments for
swaps would combine both
fixed and floating amounts
However, swap payments
are typically netted between
the fixed and floating parties
Unlike a physical bond, this
minimizes counterparty risk
No exchange of notional amounts
Netting of cashflows
Posting of collateral
Fixed
Floating
Applications for Interest Rate Swaps
Substitution
Hedging
Managing interest rate exposure
Managing high quality corporate exposure
Managing duration and curve exposure
Taking advantage of swap spread levels
Interest Rate Swaps Application:
Substitution
Collateral
Deposit
(Varies)
Buy
Cash-
Equivalent
Securities
Interest
Rate
Swaps
Broker
Deposit
(2%)
Amount
of Cash
Investment
Buy
Cash-
Equivalent
Securities
(98%)
Bond
Futures
Coupon
Bonds
Buy
Bonds
Directly
Swaps may be used as
substitutes for physical
securities to gain interest
rate exposure
Swaps may be more
attractively priced
Swaps may have more
attractive risk characteristics
Swaps facilitate cash backing
strategies
Cash invested to maintain
desired duration target and
prevent economic leverage
Substitution
Like corporate securities,
interest rate swaps trade
at a spread to Treasuries
Interest rate swap
spreads are comparable
to very high quality
corporate securities
As with other high quality
issues, the swap yield
curve closely tracks the
Treasury curve
Intermediate Credit Spreads to
Treasuries as of 09/30/04
C
r
e
d
i
t

S
p
r
e
a
d
0
1
2
3
4
5
6
3m 2Y 5Y 10Y 15Y 30Y
U.S. Treasury Yield Curve
Swap Curve
Swap vs. Treasury Yields
as of 09/30/04
Y
i
e
l
d

(
%
)
SOURCE: Bloomberg Financial Markets, Citigroup Yield Book, Lehman Brothers
37
44
70
93
228
357
0
100
200
300
400
500
TreasuryAgency Swaps A BBB BB B
Interest Rate Swaps Applications:
Hedging
Duration Contribution Exposure Duration Instrument
5.25 Years
1.00 Years
0.75 Years
3.50 Years
$100 MM) 5.25 Years Total
4.00 Years
3.00 Years
7.00 Years
$25 MM) Corporate Note
$25 MM) Mortgage Pass Through
$50 MM) Treasury Note
Benchmark Duration: 4.50 Years
Current Portfolio Duration: 5.25 Years
Reasons for using the swaps market:
Liquidity
Ability to target specific risk exposures
4.25 Years New Portfolio Duration
(1.00 Year) ($25 MM) (4.00 Years) Pay Fixed Swap
Hedging High Quality Credit Exposure
* Cash backing the swaps can be invested in LIBOR-yielding assets.
Yield premium over LIBOR
Invest in swaps instead of AAA/AA bonds*
Substitute for AAA/AA-rated
corporate universe
Company A credit is 1% of benchmark
Expect credit to underperform
Invest 1% of assets in swaps instead of company A bonds*
Capture credit spread implicit in swap rates while avoiding
company A-specific risk
Alternative investment vehicle
in cases of company-specific
underperformance concerns
Expect Company B to outperform relative to other credits
Do not want to take on additional risk
Invest in Company B and enter into swap agreement to
reduce credit exposure
Hedging vehicle for eliminating
systematic economic risk
Supply/demand distortions can occur in corporate bond
markets
Liquidity of the swap market allows for quick and efficient
exposure
Liquidity considerations
Example Rationale for using swaps
0
1
2
3
4
5
6
3m 2Y 5Y 10Y 15Y 30Y
Euro Benchmark
U.K. Government Benchmark
Y Y Y
Targeting Curve and Duration Exposure
Secular view:
Increased yields for longer
maturity UK issues
Decreased yields for longer
maturity EU issues
Interest rate swaps
provide a means to
precisely target these
duration/curve structures
Example Position
IRS Pay 5% GBP
IRS Receive 6% EUR
Investment
06/18/34
06/18/34
Maturity
(8.05)
9.65
Duration
Euro / U.K Yield Curves
Y
i
e
l
d

(
%
)
Swaps Application:
Taking Advantage of Swap Spreads
-15
-10
-5
0
5
10
15
20
25
30
35
00 01 02 03 04
Yen swap spreads are low
Expectation for swap
spreads to widen to more
normal levels
Swaps and futures provide
a means to capitalize on
these views
Pay fixed swap will benefit
from spread widening
Long futures hedges short
interest rate exposure
Example Position
Long Futures on 10 yr
Japanese Government Bond
IRS Pay 2.0%
Investment
12/01/04
06/15/05
Maturity
6.60
(6.68)
Duration
10 Year Yen Swap Spreads
Total Return Swaps
Instead of fixed-rate payments, the swap pays the rate
of return on an index
A total return swap on the Lehman Brothers Aggregate Index could
pay the return of the index versus receiving USD 3-month LIBOR
Applications
Efficiently gain exposure to a sector that is difficult to replicate
Hedging a portion of the portfolios risk versus the index
Examples
The CMBS portion of the Lehman Brothers Aggregate Index
Portfolio Application:
The CMBS Total Return Swap
The challenge:
The CMBS index represents 3%
of the LBAG
Replicating the CMBS index
with direct holdings can be
difficult and costly
The solution:
Purchase a total return swap on
the Lehman CMBS Index
Why this works:
Wall Street dealers have strong
need to hedge CMBS book
Willing to purchase protection
at a premium
Swap Terms
PIMCO pays 3 month Libor 35 bps
Dealer PIMCO
3 ML 35 bps
PIMCO receives total return of CMBS Index
Dealer PIMCO
Lehman CMBS
Total Return
Swap collateral invested
to yield Libor +
Credit Default Swaps (CDS)
At Inception:
[No money changes hands]
If no default:
If a default:
Dealer
Buys
Protection
PIMCO
Sells
Protection
Assume $50mm
notional @ LIBOR +105
PIMCO Dealer
LIBOR +105
PIMCO Dealer
$50mm
Pre-agreed on bond
for $50mm face value
Outcome equivalent to owning
a physical corporate bond
Credit Default Swap:
The protection seller
(assuming credit risk like
buying a bond) agrees to
receive a quarterly series
of payments (expressed
as a spread over LIBOR)
in return for the
protection of buyers
right to give the seller
any of the underlying
issuers bonds and be
paid par in the event
of default
918.9
2,191.6
3,583.6
4,500.0
0
1000
2000
3000
4000
5000
6000
2001 2002 2003 2004*
Credit Derivatives: Market Size
The Credit Derivatives market has experienced explosive growth
and is on pace to continue this trend
Credit Derivatives volumes are projected to reach $4.5 trillion in 2004
SOURCE: ISDA Market Survey
* Estimated as of 06/30/04
Estimate Source: British Bankers Association
The above chart is a representation of a sample portfolio and is provided for illustrative purposes only.
No guarantee is being made that any account will have the same structure or that similar results will be achieved.
U
.
S
.

$

B
i
l
l
i
o
n
s
Credit Derivatives Market Value
Whats Driving
Credit Derivatives Growth?
Changing roles of banks
Broadening credit risk arena (e.g., supplier and contract risk)
Corporate/Financial risk controls
Hedge Funds, growing absolute return appetite
Scarcity of corporate floaters/short-term debt/CP
Volatility of 2002
Default Swaps
Are They Creating Credit?
PIMCO wants to invest in Company A on a short-term
floating rate basis
TRADITIONAL
PIMCO buys $50mm of
Company A at L+95 FRNs at
par (Company A pays the
interest and principal)
OR
PIMCO sells protection on
Company A for $50mm
notional and receives L+105
There is no principal, just a
notional amount
Implication: Supply of credit risk (long or short) for a specific
issuer is no longer controlled solely by that issuer
CDS Portfolio Application:
Taking or Hedging Active Credit Risk
0
50
100
150
200
250
300
350
Oct-04 Jul-04 Apr-04 Jan-04 Oct-03
0
50
100
150
200
250
300
Ford Credit and CDS Spread
CDS Spread - Ford (lhs) Ford-OAS (rhs)
B
a
s
i
s

P
o
i
n
t
s
B
a
s
i
s

P
o
i
n
t
s
0
4,000
8,000
12,000
16,000
20,000
Dec-00 Jun-01 Dec-01 Jun-02 Dec-02
CDS 5-Yr Spread
CDS 10-Yr Spread
EMBI Argentina Spread
B
a
s
i
s

P
o
i
n
t
s
Argentina Credit and CDS Spreads
Selling protection
through CDS closely
replicates the credit
exposure of a physical
security
Conversely,
purchasing protection
through CDS protects
a portfolio from
adverse credit events
Risks and Control Measures
for Various Swap Strategies
* PIMCO maintains a very selective list of approved swap counterparties, all of which are evaluated in their financial strength and stability.
PIMCO also exchanges collateral to ensure settlement.
To gain credit
exposure
To gain spread
exposure
To gain efficient,
diverse exposure
to an index
To gain interest
rate exposure
To gain high quality
corporate exposure
Uses
Duration
Minimum credit quality
Spread duration
Approved counterparties only*
Underlying index
exposure
Counterparty exposure
Total Return Swap
Minimum credit quality
Spread duration
Default exposure
Credit spread movement
Credit Default Swap
Duration
Curve duration
Interest rate movement
Yield curve movement
Interest Rate Swap
Risk Measures Employed Risks Instrument
Counterparty Risk Management
Market values of swaps are low relative to notional values
Counterparties limited to large, diversified Broker/Dealers
Minimum credit rating of A-
Reviewed quarterly
Mutual collateral agreements
Governed by standardized (ISDA) agreements
Liquid collateral (Treasury or agency bills)
Collateralize gains on swaps in excess of $250,000
PIMCO may terminate swap if counterparty falls below A-
Swaps Summary
Benefits
Liquidity
Becoming the benchmark in many markets
Ability to customize and hedge portfolio risks
Ability to alter spread exposure
No exchange of principal minimizes counterparty risk
Risks
Similar to high quality corporate issues
Leverage
Managed through appropriate collateral and duration management
Options
Definition: The right (not obligation) to buy or sell
an asset at a set price by (or at) at specific time
Call option: The right to purchase the underlying asset
Put option: The right to sell the underlying asset
Option terminology:
Underlying: The asset to be purchased/sold upon option exercise
Strike: The purchase/sale price for the underlying asset
Option price or premium: The amount paid to obtain the right
to purchase/sell the underlying asset
Expiration date: The date by which the option must be exercised
Option Examples
Options on cash instruments
Bond option: Delivery is underlying bond
Foreign currency options: Delivery is foreign exchange
Options on derivatives
Options on Futures: Government bond futures
Swaptions: Right to enter a swap agreement
Executive stock options, warrants, convertible bonds,
callable bonds & mortgages all have important option
components
Exchange Traded Interest Rate Options
Have Grown in Importance
Exchange Traded Interest Rate Options Outstanding
SOURCE: BIS, ISDA
Note: Most data prior to 1998 is from ISDA survey. Outstanding is notional value measured at end of period, and turnover is
the total for the period. Exchange traded futures and options for commodities and single-securities is not included.
T
r
i
l
l
i
o
n
s

(
$
)
0
5
10
15
20
25
93 94 95 96 97 98 99 00 01 02 03
How are Options Used in
Fixed Income Portfolios
Hedge (long options)
Long put options may protect a portfolio from rising interest rates
Buying call options may allow a portfolio to benefit from falling
interest rates
Options provide a means to target specific bull/bear duration
levels
To add yield (written options)
To generate structural alpha
Synthetic replication: Callable, putable and convertible
securities equal: Bond +/- Option
As a substitute for physical security
Deep in the money options have little or no optionality
and can serve as straight bonds
Call Option
Buyer of a call option pays a
premium
As the value of the asset
increases, buyer of a call benefits
Put Option
Buyer of a put option pays a
premium
decreases, buyer of a put
benefits
Long Options Payout
L
o
s
s
0
0
Strike
Premium
Price of
Asset
0
G
a
i
n
L
o
s
s
0
Price of
Asset
Premium
Strike
G
a
i
n
Call Option
Seller of a call option receives a
premium
decreases, seller of a call benefits
Put Option
Seller of a put option receives a
premium
increases, seller of a put benefits
Short (Written) Options Payout
Price of
Asset
0
G
a
i
n
L
o
s
s
0
Premium
Price of
Asset
0
G
a
i
n
L
o
s
s
0
Premium
Strike
Strike
A Simple Example: A Long Call
Starting portfolio:
$100 mm cash
$100 mm 10 Year Note
Bullish on Rates Long Call
Pay premium to purchase option
on additional 10 Year Note
Rates fall:
- Exercise option to purchase
another 10 Year Note
- Exchange low duration cash
for high duration note
- Value of the portfolio increases
Rates rise:
- The option goes unexercised,
premium lost
Cash
10 Yr
Note
Long Call
10 Yr
Note
10 Yr
Note
Option Exercised
Purchased Call Option
Cash
10 Yr
Note
Starting Portfolio
A Simple Example: A Short Call
Starting portfolio:
$100 mm cash
$100 mm 10 Year Note
Bearish on Rates Short Call
Sell call option on 10 Year Note;
collect premium
Rates rise:
- The option goes unexercised
- Retained premium increases
portfolio value
Rates fall:
- Option exercised
- Duration called away
from portfolio
Cash
Cash
Short Call
10 Yr
Note
10 Yr
Note
Option Unexercised
Written Call Option
Cash
10 Yr
Note
Starting Portfolio
The Duration of Options
The duration of an option measures the price
sensitivity of the option to changes in interest rates
Delta: Option price sensitivity to movement in price
of underlying asset
Varies from 0 to 1
An option with a delta of 0.5 is at the money
The modified duration of an option is:
Modified Duration of Option = Modified Duration of Underlying x
Option Delta x (Price of Underlying Instrument/Price of Option)
Long Options: Positive Convexity
Owners of call options:
As rates fall and prices rise,
portfolio duration increases
Positive convexity
Owners of put options:
As rates rise and prices falls,
portfolio duration decreases
Positive convexity
Portfolio Duration Change
Rates Rise Rates Fall
Price
Buyers of
call options
Price
Buyers of
put options
D
u
r
a
t
i
o
n

C
h
a
n
g
e
+
_
D
u
r
a
t
i
o
n

C
h
a
n
g
e
+
_
Short Options: Negative Convexity
Sellers of call options:
As rates fall and prices rise,
portfolio duration decreases
Negative convexity
Sellers of put options:
As rates rise and prices falls,
portfolio duration increases
Negative convexity
Sellers of
call options
Sellers of
call options
Price
Price
D
u
r
a
t
i
o
n

C
h
a
n
g
e
+
_
D
u
r
a
t
i
o
n

C
h
a
n
g
e
+
_
Price Yield of Non-Callable Bond
Yield
Portfolio Application: Replicating MBS
Written (short) options can
replicate physical securities
such as MBS
MBS consists of:
Non-Callable Agency bond
Written call option
This can be replicated by:
Purchasing a non-callable
Agency bond
Writing a call option
This combination provides
duration/convexity posture
similar to MBS
D
u
r
a
t
i
o
n

C
h
a
n
g
e
+
Sellers of
call options
_
Price
P
r
i
c
e
Non-Callable Agency Bond
Written Option
Portfolio Application: Selling Volatility
Macro view: Interest rates will
remain range bound over a
given period
Portfolio implementation:
Write call option on 10 Year
Treasury Future
Write put option on 10 Year
Treasury Future
Strategy benefits portfolio if
rates stay within targeted range
Duration impact consistent with
desired exposure
Rates rise: increase duration
Rates decline: reduce duration
Write Call Write Put
0
Profit and Loss Analysis
L
o
s
s
G
a
i
n
4.0% 4.5% 5.0% 5.5% 6.0%
Keep Premium
U.S. Treasury Bond Yield
Estimated Duration Impact on Portfolio
+
_
D
u
r
a
t
i
o
n

C
h
a
n
g
e
4.0% 4.5% 5.0% 5.5% 6.0%
Portfolio Application: Selling Volatility
to Generate Structural Alpha
Option buyers typically
overpay for the insurance
provided by options
Consequently, the volatility
implied by an option price is
not typically realized in the
market
This benefits sellers of
options over the long term
As a result, selling options
may provide a means to
generate structural alpha
-30
-20
-10
0
10
20
30
40
94 | 95 | 96 | 97 | 98 | 99 | 00 | 01 | 02 | 03 |
Implied 3-Month Volatility Less Actual 3-Month
Volatility (2-Year Treasuries)
Risk Controls
Risks
Options can affect duration and convexity of portfolio
Options can magnify gains/losses if not properly controlled
Risk controls
Duration guardrails stated in investment guidelines
Daily measurement of duration and convexity (delta-weighted)
Bull & Bear duration scenario analysis
Agenda
Continued Stable
Climb in China, Japan
Steady Economic
Growth in U.S.
Increased Growth
in Europe
U.S.
consumer
slowdown
Slowdown
shock in
Asia
Geopolitical
instability
Central Bank
interest rate
hikes
Twin deficits
(financed
by Asian
central
banks)
Highly levered
private
sector
restrains
Fed
High growth
in China
Increased
government
control
Cheap
money
Global Economys High Wire Act
Conditions for Instability Accelerating
Secular Implications
GDP Growth:
U.S. stabilizes around 2%
Europe, Japan move toward 2%
Inflation peaks near 4%
Reactive Fed
Deflation
I nflation
Risks Risks Goals
Opinion is subject to change without notice.
Modest Growth As Stimulus Fades,
Corporate Sector Proceeds Cautiously
-
Higher oil prices drag on growth
Euroland growth dependent on external
demand
Lack of confidence, lingering excess capacity
Fiscal and monetary stimulus waning
Risk of Chinese hard landing has abated
Modest growth in capital spending to maintain
capital stock
Corporate sector has ample liquidity for
investment
U.S. consumer spending remains net positive;
signs of domestic demand growth in Asia
+
Neither Boom Nor Bust as Global Economy Muddles Along
U.S. interest rates rangebound near current levels
Higher volatility given leverage in the system
Central bankers will remain accommodative given benign
inflationary pressures
Global growth will slow relative to recent robust pace
Cyclical Implications
Opinion is subject to change without notice.
Duration and Yield Curve Management
Measuring Sector Exposure
Measuring Spread Exposure
Measuring Futures Exposure
Measuring Swap Exposure
Measuring Swap Exposure
Measuring Total Return Swap Exposure
Measuring Option Exposure
Conclusion
Bond investors are paid to assume risk. The four
primary risks in a bond portfolio are:
Interest Rate Risk
Volatility Risk
Credit Risk
Liquidity Risk
These risks are present in both cash and derivative
instruments
Derivative instruments offer an efficient means to gain
and/or reduce risk exposure
The goal of fixed income managers is to achieve an
appropriate balance between risk and return regardless
of the instrument employed

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