FinQuiz smart summary, fixed income portfolio management

5.1 Combination Strategies Active / passive combination ⇒ core component of portfolio to passive strategy to replicate an index & balance to active component return maximization strateg

“FIXED-INCOME PORTFOLIO MANAGEMENT-PART II”

5 OTHER FIXED-INCOME STRATEGIES

No of alternatives available to enhance performance whether managing against index or liabilities

5.1 Combination Strategies

Active / passive combination ⇒ core component of portfolio to passive strategy (to replicate an index) & balance to active component (return maximization strategy)

Active / immunization combination ⇒ immunized portfolio provide assured return while second portfolio use high return / risk strategy

5.2 leverage

5.2.1 Effects of Leverage

Leverage
equity duration given duration of liabilities < duration of assets

A&L represent market value of assets & liabilities

RA = Repurchase Agreements

SD = Standard Deviation CDS = Credit Default Swap I.R = Interest Rate

BSA = Breakeven Spread Analysis EMD = Emerging Market Debt RFR = Risk Free Rate

5.2.2 Repurchase Agreements

same on a later date

Repo rate = diff b/w selling price & purchase price

over

(cheaper than physical delivery, but still fee & transfer charges)

charges)

transactions)

5.3 Derivatives-Enabled Strategies

Use of derivatives can be thought as means to create, reduce or magnify factor exposures of an investment

5.3.1 Interest Rate Risk

Sensitivity of F.I portfolios to I.R change

matched to maintain portfolio duration

5.3.2 Other Risk Measures

(difficult in case of option securities)

are;

Alternative Measures

Lose statistical accuracy (use half data)

specified return target

money term

Value at risk

Probability & loss in monetary terms

5.3.3 Bond Variance versus Duration

covariance b/w each pair of securities

No of parameters = No of bond (No of bonds + 1) / 2

characteristics change with passage of time

5.3.4 Interest Rate Futures

6% coupon bond

Conversion factor ⇒ based on price the deliverable bond would sell for at beginning

of delivery month

Cheapest-to-deliver ⇒ least expensive bond selected by short

Quality or SWAP option ⇒ acceptable treasury issue to deliver option

Timing option ⇒ day of actual delivery in delivery month

Wild card option ⇒ delivery after closed of exchange

5.3.4.1 Strategy with Interest Rate Futures

Liquidity, cost effectiveness & easy to take short position are key advantages of using futures

where

DT = target duration

DI = initial duration

PI = initial MV of portfolio

DCTD = duration of cheapest-to-deliver

PCTD = price of CTD

Basis risk ⇒ basis (diff b/w cash price & future price) change in an unpredictable way

Cross hedge ⇒ bond to be hedged is not identical to bond underlying in future contract

Sources of Hedging Errors

Inaccurate duration calculation

Inaccurate projected basis value

Inaccurate yield β

5.3.5 Interest Rate Swaps

Contract b/w two parties to exchange periodic interest payments based on notional principal

5.3.5.1 Dollar Duration of an Interest Rate Swap 5.3.5.2 Application of a Swap to Asset/Liability Management

SWAP party with pay floating & receive fixed can view as;

long a fixed rate bond + short on floating-rate bond

$ duration = DD of fixed rate bond - DD of floating rate bond

Alter CF to better matches assets &liabilities

5.3.6 Bond & Interest Rate Options

the right to sell

5.3.6.1 Bond Option & Duration

5.3.6.2 Hedging with Options

Protective Put Buying Covered Call Writing

portfolio

option cost

trade much higher or much lower than its present level

protection if I.R
)

If I.R  price appreciation is limited (liability
as rates go down)

if price are essentially going nowhere

Collar ⇒ combination of cap & floors

5.3.7 Credit Risk Instruments

Default Risk Credit Spread Risk Downgrade Risk

Issuer may fail to meet its obligations

Spread b/w risky bond &

Rf bond may vary after purchase

Major rating agency may lower its rating for an issuer

5.3.7.1 Products That Transfer Credit Risk

Credit derivative exist to package & transfer credit risk

of a financial instrument or institution to another party

Types of Credit Derivatives

Binary options Credit Spread options

on spread over benchmark rate

options maturity –K) × notional amount × risk factor, 0] where K is strike spread & risk factor value ∆ for 1bps

∆in spread

negative credit event

(default or rating)

diff b/w X-S when credit

event occur & nothing if

no credit event

credit spread

pay off = (credit spread at forward maturity – contracted credit spread) × notional amount × risk factor

credit exposure of an asset issued by reference entity from protection buyer to protection seller

usually by banks

protection in CDS rather to selling or shorting asset

6 INTERNATIOANL BOND INVESTING

Local currency correlations > $ term correlation (due to currency volatility)

6.1 Active versus Passive Management

High opportunities for active management due to inefficiencies in international markets

Active Management Value Creation

Bond Market Selection Currency Selection Duration Management

Global economic factors analysis to select national markets

Ability to forecast certain exchange rates

Distinct knowledge & skills required (separately managed)

fixed income derivatives are used

Sector Selection Credit analysis of issuers Investing in markets outside benchmark

Wide range of coupon, ratings &

maturities provide opportunities through credit analysis

Manager can add value through superior credit analysis

sovereign bonds

portfolio duration, recognize correlation b/w movements in I.R in home country

& each nondomestic market

∆ in value of foreign bond = - duration ×∆ in foreign yield given ∆ in domestic yield ×100

∆y foreign = a + β ∆y domestic

β (country beta) = correlation (∆y foreign, ∆y domestic) ×σ foreign / σ domestic

6.2 Currency Risk

loss occurs & vice versa

6.2.1 Interest Rate Parity

Exchange rate difference = Rf IR difference (f = id – if)

f = (F- So) / So

Where

6.2.2 Hedging Currency Risk

Decision on how much currency risk to hedge has important impact on return

Type of currency hedge

Use forward contract to currency hedge (b/w bond currency &

home currency)

Use forward contract b/w home currency & currency highly correlated to bond currency

outside home currency

another less risky exposure

6.3 Breakeven Spread Analysis

a foreign yield advantage

domestic yield
& foreign yield

countries durations

6.4 Emerging Market Debt

EMD has low correlation with domestic debt portfolios, so offer favorable diversification properties

6.4.1 Growth & Maturity of the Market

(securitization of external bank loan)

investment grade debt increased)

6.4.2 Risk & Return Characteristics

return

private corporation

High volatility & significant negative skewness

difficult in case of default

6.4.3 Analysis of Emerging Market Debt

Analyst must determine willingness & ability of issuers to pay their debt obligation (consider country’s fundamentals)

create mispricing opportunities)

political risk on investment performance

debt

7 SELECTING A FIXED-INCOME MANAGER

Focus on selection of active & consistent positive style-adjusted alphas creative manager

7.1 Historical Performance as a Predictor of Future Performance

to zero

7.2 Developing Criteria for the Selection

Selection bets

analysis skill

decomposing portfolio’s return

Historical style may explain

type of biases & quality of

views

Information about research methods, alpha & changes in portfolio

Correlation of alphas

Prefer low correlation among manager’s alphas to control portfolio risk

7.3 Comparison with Selection of Equity Managers

Similarities b/w F.I & equity mangers