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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 managers forecasting ability. Portfolios 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 portfolios return through valuation (e.g. undervalued bonds).

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

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2 Study Session # 9, Reading # 23

Active Strategies

Active management by larger risk factor mismatches Larger mismatch on primary risk factors than type 3. Slight portfolio duration adjustment from benchmarked indexs duration.

Full blown active management

Aggressive mismatches on duration, sector weights & other factors.

3.2 Indexing (Pure & Enhanced) Indexing exists for several reasons e.g. Lower fee. Outperforming the index on consistent basis is difficult. Broad bond index portfolio provides diversification.

3.2.1 Selection of a Benchmark Bond Index: General Considerations Index characteristics should closely match portfolio characteristics. Factors in Benchmark selection

Market value risk As maturity & duration of portfolio market risk . Risk averse investor short or medium term index is appropriate.

Income risk Long term portfolio lock income stream over a long time period resulting in lesser risk than short portfolio.

Credit risk Credit risk of index should be appropriate for indexed portfolios role in investors overall portfolio.

Liability framework Risk Match investment characteristics of assets & liabilities. Choose index that reflects nature of liabilities.

Managers index portfolio mimics benchmark bond index mimics market of all bonds.

3.2.2 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.C

Completely effective indexed portfolio exact same risk profile as benchmark.

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3 Study Session # 9, Reading # 23

Techniques of Risk Matching

Cell-matching technique Divide index into cells that represent qualities & reflect risk factors of index. Selected bonds from each cell have same weights in portfolio as cell has in the index.

Multifactor model technique Use set of risk factors that derive return.

Risk factors

1. Duration

2. Key rate duration & present value distribution of cash flows

Effective duration sensitivity of index price to relatively small parallel shifts. Convexity estimate price adjustment missed by duration. Portfolio duration should match the index duration.

Key rate duration Measures the effect of shifts in key points along the Y.C. Determines relative attractiveness of various portfolio strategies (e.g. barbell, bullet).

PVD of CF Four step process: Project index CF for each period & take PV & then sum all PV. Divide each periods PV to total PV. Multiply each periods duration with its % (from step 2). Adding each periods contribution to durations & then dividing each periods duration contribution with total duration shall result in a distribution. By duplicating this distribution, non parallel Y.C. changes affect portfolio and index similarly.

3. Sectors & quality percent Match portfolios % weight in various sectors & qualities with the index.

4. Sectors duration contribution Sectors weight x sector duration. Portfolio should have same duration exposure to each sector as the benchmark.

5. 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.

6. Sector/coupon/ maturity cell weights Dont match convexity of index in case of callable bonds (high transactions costs). Match sectors, coupon & maturity weights of callable sector in portfolio with benchmark.

7. Issuer exposure Too few securities in portfolio, event risk is high.

3.2.3 Tracking Risk Active return = portfolios return benchmark indexs return. Tracking risk (tracking error) standard deviation of active return.

Smaller the tracking risk, closer the portfolios return matches benchmark indexs return. Tracking risk can be completely eliminate by purchasing all securities of benchmark (ignore transaction costs & expenses).

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4 Study Session # 9, Reading # 23

3.2.4 Enhanced Indexing Strategies Indexed portfolio underperforms the index due to expenses & transaction costs. Index enhancement strategies are used to cover return difference.

Enhanced Indexing Strategies

1. Low Cost Enhancements Tight control on trading costs & management fees.

2. Issue Selection Enhancements Select mispriced securities relative to theoretical value

3. Yield curve positioning Overweight in undervalued areas of Y.C & vice versa.

4. Sector & quality positioning

5. Call exposure positioning Callable underperform relative to effective duration models predictions when yield . Underweight these issues in this condition.

Short duration corporate has best yield spread per unit of risk so maintain a yield tilt towards short corporate (e.g. 5 years).

Underweight or overweight of sectors or qualities periodically.

3.3 Active Strategies

3.3.1 Extra Activities for the Manger

3.3.2 Total Return Analysis & Scenario Analysis

Identify the mismatches to be exploited (e.g. duration). Extrapolate the markets expectations from market data (e.g. F.R from S.R). Forecast the inputs & compare with market expectations. Identify mispriced securities.

Total return Analysis Assess the expected effect of a trade on portfolios total return. Sources of total return are; Coupon. Reinvestment income. 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. Manager can assess distribution of possible outcome, reversely apply the analysis to reach inputs, can analyze individual inputs and can apply analysis to entire trading strategies.

Where n are periods in investment horizon.

Relies just one set of assumptions.

3.4 Monitoring / Adjusting the Portfolio & Performance Evaluation Covered in detail in other readings.

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5 Study Session # 9, Reading # 23



CF Matching

Single period Immunization

Multiple liability immunization

Immunization for general CF

Dedication strategies designed to meet funding needs of investors. Mostly passive strategies, may add some active management elements. More uncertain the liabilities more elements of active management.

4.1.1 Immunization Strategies Immunization strategy for locking in guaranteed rate of return over a particular time horizon. Purpose of immunization off setting reinvestment risk with price risk. Classical Single-Period Immunization Important characteristics of immunization are; Specified time horizon. Assured rate of return. Protect from effect of I.R changes on portfolio value at horizon date. To protect portfolios target value against change in yield, invest in portfolio whose; Duration is equal to investment horizon. PV of CF is equal to PV of liabilities. Rebalancing an Immunized Portfolio Duration of portfolio change due to market yield changes or because of passage of time so rebalancing required. Manager should tradeoff b/w transaction costs & duration straying from target. Determining the Target Return Given the term structure or Y.C, immunized rate of return can determined. Upward sloping Y.C target rate of return is < YTM (because low reinvestment return) & vice versa for downward sloping Y.C. Alternative measure of target rate of return yield of zero coupon bonds. Most conservative method for discounting liabilities treasury spot curve. More realistic approach Y.C implied by securities held.

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6 Study Session # 9, Reading # 23 Time Horizon Immunized time horizon = portfolio duration. Portfolio duration weighted avg. of individual security duration. Dollar Duration & Controlling Positions Dollar duration = duration x portfolio value x .01. Portfolio duration sum of duration of component securities. Generally in ALM investor rebalance $ duration to a desired level as; Move forward in time & include shift in Y.C (calculate new MV, duration & $ duration) Calculate the rebalancing ratio as original duration / new $ duration Subtract one from this ratio & convert it into %. Cash needed for rebalancing = new MV x desired % changes (from step2). Spread Duration Spread duration tool for management of spread risk. Spread duration of a portfolio market weighted avg. of spread duration of component securities.

Types of spread duration

Nominal spread Spread of bond or portfolio above the treasury yield.

Static spread Constant spread above S.R curve that equates securities price to MV.

Option Adjusted Spread Spread over the benchmark yield spread attributable to embedded option.

4.1.2 Extensions of Classical Immunization Theory Assumptions of Classical immunization Theory

Parallel shifts in Y.C

Portfolio is valued at fixed horizon date & no interim cash inflows & outflows

Target value of investment is value at horizon date if I.R structure dont change

Extensions of Classical Immunization

1. Nonparallel shifts

Multifunctional or key rate duration.

Construct a bullet portfolio (CF concentrated to horizon date).

2. This extension overcomes limitations of fixed horizon. (Multiple liability immunization & arbitrary CF case).

3. Return maximization (because risk minimization may be too restrictive in certain cases).

4. Contingent immunization (immunization with elements of active management). Possible when immunized rate of return > required rate of return. Cushion spread immunized rate-minimum acceptable return.

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7 Study Session # 9, Reading # 23 Duration & convexity of Assets & Liabilities Economic surplus = MV of assets PV of liabilities. Portfolios assets & liabilities duration & convexity should be well matched otherwise economic surplus change will not be offsetting. Types of Risk

Interest rate risk Value of portfolio inversely related to interest rates, shortfall may be possible if I.R rise.

Contingent claim risk Risks attached with embedded option bonds (e.g. when IR callable bond face reinvestment risk).

Cap risk Risk that asset return may be capped due to floating rate security. Risk Minimization for Immunized Portfolio (1st Extention) Portfolio with minimum exposure to arbitrary I.R. changes. Construct bullet portfolio instead of barbell (low reinvestment risk so low immunization risk). If pure discount instrument with maturity = investment horizon immunization risk is zero. If F.R changes by arbitrary function, portfolio value depends on product of two terms: Structure of investment portfolio (M2). Function of I.R movement. Immunization risk measure (M2) also called maturity variance measures variance of time to payment around horizon date. Optimal immunized portfolio found using linear programming. C.I for target return using immunization risk measure as; C.I = target return (K) (S.D of target return) where K is no. of SD, in confidence level, K & wider the band around expected return.

4.1.3 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.

Assets duration distribution must have a wider range than liabilities.

Models for MLI to arbitrary Y.C shifts. Same immunization risk measure as in single investment horizon. Optimal immunization strategy minimize immunization risk.

4.1.4 Immunization for General Cash Flows Used if all investment funds are not available at time of portfolio construction. Duration of total cash inflow stream should be equal to liability horizon. Rate of return guaranteed on future contribution is not S.R rather F.R.

4.1.5 Return Maximization for Immunized Portfolios Prefer higher yielding portfolio, despite higher risk, if it provides substantial in return with little effect on immunization risk. Minimum acceptable return = required terminal value + safety margin. Portfolio is classically immunized (trade off b/w risk & return against nonparallel shifts is considered.

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8 Study Session # 9, Reading # 23

4.2 Cash flow Matching Strategies Alternative to multiple liability immunization. Select securities to match timing & amount of liabilities. Linear programming can be employed to construct least-cost portfolio. More excess cash, greater the risk of strategy (reinvestment risk). 4.2.1 Cash Flow Matching versus Multiples Liability Immunization Minimum immunization risk approach is better than CF matching because less money is used to fund liabilities, two factors related to this are: Two Factors

CF matching require conservative rate of return assumption for short-term cash & balances. Immunized portfolio fully invested at remaining horizon duration.

Reinvestment for excess cash extend many years into the future, so conservative I.R assumption under CF method. Under immunized portfolio funding is achieved through rebalancing.

4.2.2 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). Allow short term borrowings (reduce cost of liability funding).

Combination matching Portfolio that is duration as well as CF matched (in early year).

Advantage Meet liquidity needs in initial period. Reduce nonparallel shift risk in early years.

Disadvantage Liability funding cost is greater than MLI.

4.2.3 Application Considerations Universe Considerations Consider quality, liquidity & duration of securities when constructing portfolio. Optimization

Immunized portfolio Optimization takes the form of minimizing maturity variance.

CF Matching To minimize initial portfolio cost. Monitoring Periodic performance measurement. Bullet portfolio return to date should only slightly fluctuate from original target return. Multiple liability immunized portfolio can be monitored through economic surplus. Transaction costs These costs must be considered in initial immunization as well as in rebalancing.

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