1 Study Session # 9, Reading # 23


SR = spot rates CI = confidence interval SD = standard deviation MLI = multiple liability immunization

1. INTRODUCTION Focus is on effective construction of F.I portfolio & related issues. F.I portfolio manager manages funds against bond market index or client liabilities.

FI = fixed income YC = yield curve PVDCF = present value distribution of cash flows FR = forward rates

2. A FRAME FOR FIXED-INCOME PORTFOLIO MANGEMENT Type of investors (based on investment objective)

Benchmark-relative basis

Liability based

Specific bond market index as benchmark (no liability matching). Consider risk of bond portfolio in relation to benchmarked index as well as overall portfolio.

Meeting liabilities become the benchmark for portfolio. Liabilities can be legal promises (e.g. pension), borrowing money & others.


Passive Assume market expectations are correct. Portfolio manager accept avg. risk & return level. Portfolio closely tracks the benchmark index.

Active Relies on manager’s forecasting ability. Portfolio’s return should increase if manager has superior forecasting ability.

3.1 Classifications of strategies

Passive Strategies

Pure bond indexing (or full replications approach)

Enhanced indexing by matching primary risk factor

Enhanced indexing by small risk factor mismatches

Duplicate the index & same weights as in index. Very difficult & expensive to construct. Index may contain very illiquid & infrequently traded bonds so full replication is difficult.

Sampling approach to match primary risk factors (duration, twists in yield curve & spread duration) Reduce construction & maintenance cost but less closely track index. Enhanced portfolio’s return through valuation (e.g. undervalued bonds).

Match duration. Mismatches are small & to cover administrative cost.

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2. Outperforming the index on consistent basis is difficult. Slight portfolio duration adjustment from benchmarked index’s duration.com.C Completely effective indexed portfolio ⇒ exact same risk profile as benchmark.1 Selection of a Benchmark Bond Index: General Considerations Index characteristics should closely match portfolio characteristics.g.2 Risk in Detail: Risk Profiles Yield Curve Changes Parallel shifts Interest rate risk Non parallel shifts Yield curve risk Twists of yield curve Curative change in Y. Credit risk Credit risk of index should be appropriate for indexed portfolio’s role in investor’s overall portfolio. Factors in Benchmark selection Market value risk As maturity & duration of portfolio market risk . All rights reserved. Broad bond index portfolio provides diversification.2. Lower fee. 3. Choose index that reflects nature of liabilities. Risk averse investor ⇒ short or medium term index is appropriate. Liability framework Risk Match investment characteristics of assets & liabilities. Manager’s index portfolio ⇒ mimics ⇒ benchmark bond index ⇒mimics ⇒market of all bonds. Income risk Long term portfolio lock income stream over a long time period resulting in lesser risk than short portfolio. 3. Copyright © FinQuiz. . sector weights & other factors.2 Study Session # 9. Reading # 23 Active Strategies Active management by larger risk factor mismatches Larger mismatch on primary risk factors than type 3. Full – blown active management Aggressive mismatches on duration. 3.2 Indexing (Pure & Enhanced) Indexing exists for several reasons e.

g. Copyright © FinQuiz. Risk factors 1. barbell. Issuer exposure Too few securities in portfolio. Duration 2. closer the portfolio’s return matches benchmark index’s return. 7. Adding each period’s contribution to durations & then dividing each period’s duration contribution with total duration shall result in a distribution. . Key rate duration Measures the effect of shifts in key points along the Y. Portfolio duration should match the index duration. Reading # 23 Techniques of Risk Matching Cell-matching technique Divide index into cells that represent qualities & reflect risk factors of index. Divide each period’s PV to total PV. Determines relative attractiveness of various portfolio strategies (e. Smaller the tracking risk. Sectors & quality percent Match portfolio’s % weight in various sectors & qualities with the index. Quality spread duration contribution Spread duration ⇒ price of non treasury security change due to 100bps change in spread. Match quality spread duration of portfolio with index. 4. coupon & maturity weights of callable sector in portfolio with benchmark. By duplicating this distribution.3 Tracking Risk Active return = portfolio’s return – benchmark index’s return. Sector/coupon/ maturity cell weights Don’t match convexity of index in case of callable bonds (high transactions costs). Portfolio should have same duration exposure to each sector as the benchmark. event risk is high. Selected bonds from each cell have same weights in portfolio as cell has in the index.3 Study Session # 9. Sectors duration contribution Sectors weight x sector duration.C.com. 5.2. bullet). PVD of CF Four step process: Project index CF for each period & take PV & then sum all PV. 3. 3.C. 6. Tracking risk can be completely eliminate by purchasing all securities of benchmark (ignore transaction costs & expenses). All rights reserved. Multifactor model technique Use set of risk factors that derive return. Key rate duration & present value distribution of cash flows Effective duration ⇒ sensitivity of index price to relatively small parallel shifts. non parallel Y. Tracking risk (tracking error) ⇒standard deviation of active return. Match sectors. Multiply each period’s duration with its % (from step 2). changes affect portfolio and index similarly. Convexity estimate price adjustment missed by duration.

g. Sources of total return are.3. Underweight or overweight of sectors or qualities periodically.1 Extra Activities for the Manger 3. Yield curve positioning Overweight in undervalued areas of Y.R from S. 4.g.C & vice versa. duration). Low Cost Enhancements Tight control on trading costs & management fees.2.3 Active Strategies 3. Enhanced Indexing Strategies 1. reversely apply the analysis to reach inputs. Where n are periods in investment horizon. Underweight these issues in this condition. Call exposure positioning Callable underperform relative to effective duration model’s predictions when yield . 3. Manager can assess distribution of possible outcome. 5 years). 3.4 Monitoring / Adjusting the Portfolio & Performance Evaluation Covered in detail in other readings. Forecast the inputs & compare with market expectations. Index enhancement strategies are used to cover return difference. Sector & quality positioning 5. All rights reserved. . Coupon. Reading # 23 3.4 Enhanced Indexing Strategies Indexed portfolio underperforms the index due to expenses & transaction costs. Relies just one set of assumptions. 2. ∆ in price Semiannual total return = (total future dollars /full price of bond) 1/n -1 Scenario Analysis Evaluate impact of trade on total return under all sets of assumptions. Issue Selection Enhancements Select mispriced securities relative to theoretical value 3.4 Study Session # 9. Copyright © FinQuiz.R). F.com. can analyze individual inputs and can apply analysis to entire trading strategies. Identify mispriced securities.3. Total return Analysis Assess the expected effect of a trade on portfolio’s total return.g. Extrapolate the market’s expectations from market data (e.2 Total Return Analysis & Scenario Analysis Identify the mismatches to be exploited (e. Short duration corporate has best yield spread per unit of risk so maintain a yield tilt towards short corporate (e. Reinvestment income.

MANAGEING FUNDS AGAINT LIABILITIES 4.5 Study Session # 9.1 Immunization Strategies Immunization ⇒ strategy for “locking in” guaranteed rate of return over a particular time horizon.C ⇒ target rate of return is < YTM (because low reinvestment return) & vice versa for downward sloping Y. Purpose of immunization ⇒ off setting reinvestment risk with price risk. Specified time horizon.1.1.1. Copyright © FinQuiz.com. Protect from effect of I.R changes on portfolio value at horizon date. invest in portfolio whose. Reading # 23 4. PV of CF is equal to PV of liabilities. .1 Dedication Strategies Immunization CF Matching Single period Immunization Multiple liability immunization Immunization for general CF Dedication strategies ⇒ designed to meet funding needs of investors.2 Rebalancing an Immunized Portfolio Duration of portfolio change due to market yield changes or because of passage of time so rebalancing required.1. immunized rate of return can determined. 4.3 Determining the Target Return Given the term structure or Y. Most conservative method for discounting liabilities ⇒ treasury spot curve. Assured rate of return. Manager should tradeoff b/w transaction costs & duration straying from target. 4.1.1. More uncertain the liabilities ⇒ more elements of active management. All rights reserved. may add some active management elements. Mostly passive strategies. Duration is equal to investment horizon. 4. 4.1 Classical Single-Period Immunization Important characteristics of immunization are.C. More realistic approach ⇒ Y. Alternative measure of target rate of return ⇒yield of zero coupon bonds.1. To protect portfolio’s target value against change in yield. Upward sloping Y.C implied by securities held.C.

Cushion spread ⇒ immunized rate-minimum acceptable return.1. Construct a bullet portfolio (CF concentrated to horizon date). Reading # 23 4. Cash needed for rebalancing = new MV x desired % changes (from step2).1.1. Types of spread duration Nominal spread Spread of bond or portfolio above the treasury yield. 2. 4. Generally in ALM investor rebalance $ duration to a desired level as. of spread duration of component securities. 4.1. Move forward in time & include shift in Y. Possible when immunized rate of return > required rate of return.1. of individual security duration.R structure don’t change Extensions of Classical Immunization 1. Contingent immunization (immunization with elements of active management). Static spread Constant spread above S.1. 3. .R curve that equates securities price to MV.6 Spread Duration Spread duration ⇒ tool for management of spread risk.C (calculate new MV.5 Dollar Duration & Controlling Positions Dollar duration = duration x portfolio value x . 4. duration & $ duration) Calculate the rebalancing ratio as original duration / new $ duration Subtract one from this ratio & convert it into %.2 Extensions of Classical Immunization Theory Assumptions of Classical immunization Theory Parallel shifts in Y. 4.6 Study Session # 9. Portfolio duration ⇒ weighted avg. Nonparallel shifts Multifunctional or key rate duration. This extension overcomes limitations of fixed horizon. (Multiple liability immunization & arbitrary CF case). All rights reserved. Copyright © FinQuiz.01. Option – Adjusted Spread Spread over the benchmark yield – spread attributable to embedded option. Spread duration of a portfolio ⇒ market weighted avg. Return maximization (because risk minimization may be too restrictive in certain cases).com.4 Time Horizon Immunized time horizon = portfolio duration.C Portfolio is valued at fixed horizon date & no interim cash inflows & outflows Target value of investment is value at horizon date if I.1. Portfolio duration ⇒ sum of duration of component securities.

2. Minimum acceptable return = required terminal value + safety margin. Construct bullet portfolio instead of barbell (low reinvestment risk so low immunization risk). If F.R changes by arbitrary function. Same immunization risk measure as in single investment horizon.R.1. 4.2 Types of Risk Interest rate risk Value of portfolio inversely related to interest rates. .R rather F.5 Return Maximization for Immunized Portfolios Prefer higher yielding portfolio.2. C.I = target return ± (K) (S.R rise. Duration of total cash inflow stream should be equal to liability horizon. Immunization risk measure (M2) also called maturity variance measures variance of time to payment around horizon date. changes.D of target return) where K is no. Copyright © FinQuiz.g.R. when IR callable bond face reinvestment risk). despite higher risk.C shifts. Models for MLI to arbitrary Y.2.R movement. C. 4.1. Function of I. portfolio value depends on product of two terms: Structure of investment portfolio (M2).1.1.1 Duration & convexity of Assets & Liabilities Economic surplus = MV of assets – PV of liabilities. Contingent claim risk Risks attached with embedded option bonds (e. Portfolio is classically immunized (trade off b/w risk & return against nonparallel shifts is considered.3 Multiple Liability Immunization (2nd Extention) Necessary conditions for MLI (parallel shifts) PV of asset = PV of liabilities Composite duration of portfolio must be equal to composite duration of liabilities.I for target return using immunization risk measure as. 4. All rights reserved.1. Rate of return guaranteed on future contribution is not S. shortfall may be possible if I.7 Study Session # 9. of SD. Cap risk Risk that asset return may be capped due to floating rate security. K & wider the band around expected return.1. if it provides substantial in return with little effect on immunization risk. Optimal immunized portfolio found using linear programming.4 Immunization for General Cash Flows Used if all investment funds are not available at time of portfolio construction. 4. Reading # 23 4.3 Risk Minimization for Immunized Portfolio (1st Extention) Portfolio with minimum exposure to arbitrary I. in confidence level. Optimal immunization strategy ⇒ minimize immunization risk. Assets duration distribution must have a wider range than liabilities. If pure discount instrument with maturity = investment horizon⇒ immunization risk is zero.com. Portfolio’s assets & liabilities duration & convexity should be well matched otherwise economic surplus change will not be offsetting. 4.

Immunized portfolio fully invested at remaining horizon duration. Bullet portfolio ⇒ return to date should only slightly fluctuate from original target return.2.R assumption under CF method. Reinvestment for excess cash extend many years into the future. 4.2 Optimization Immunized portfolio Optimization takes the form of minimizing maturity variance.2 Extensions of Basic Cash Flow Matching Symmetric CF matching Liability can be met through CF occurring before & after the liability date (in basic CF matching CF must be occur before liability date).1 Universe Considerations Consider quality. 4. 4.2. Reading # 23 4. Advantage Meet liquidity needs in initial period. Disadvantage Liability funding cost is greater than MLI.3 Monitoring Periodic performance measurement.3. two factors related to this are: Two Factors CF matching require conservative rate of return assumption for short-term cash & balances. Under immunized portfolio funding is achieved through rebalancing.3. so conservative I. Multiple liability immunized portfolio can be monitored through economic surplus. Copyright © FinQuiz.3.2. greater the risk of strategy (reinvestment risk). 4.2.3. Allow short term borrowings (reduce cost of liability funding).2. More excess cash. liquidity & duration of securities when constructing portfolio.3 Application Considerations 4.8 Study Session # 9.1 Cash Flow Matching versus Multiples Liability Immunization Minimum immunization risk approach is better than CF matching because less money is used to fund liabilities. . Combination matching Portfolio that is duration as well as CF matched (in early year).2 Cash flow Matching Strategies Alternative to multiple liability immunization.2.com. Reduce nonparallel shift risk in early years. 4. Select securities to match timing & amount of liabilities.4 Transaction costs These costs must be considered in initial immunization as well as in rebalancing. CF Matching To minimize initial portfolio cost.2. Linear programming can be employed to construct least-cost portfolio. All rights reserved. 4.

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