Quandamental TM Approach to Fixed Income Management Ron D’Vari, CFA, Managing Director State Street Research and Management Fixed Income Forum, San Diego July 19, 2002

2 Traditional Fixed Income Management Styles Need To Be Augmented n Macro Shop –Interest rates and curves are not as trendy and predictable –Shocks are frequent and can ruin several years of performance –Bets need to become tilts: calculated, diversified, mild, and gradual n Credit Shop – Credit markets shocks are becoming unavoidable – Concentrated credit portfolios have unacceptable risks –Credit risk need to be evaluated in the portfolio context n Mortgage Shop –True arbitrage opportunities are few and far in between –No strategic value in writing options –Bets need to be explicit and become tilts

3 QUANDAMENTAL TM Process n Ensure value is added consistently over time using disciplined processes –Formulation of consistent winning strategies –Product templates and maps sources of alpha and tracking error Probabilistic evaluation of tactical and strategic portfolio biases n Facilitate creative decision making process –Blend creative fundamental thinking with quantitative methods –Disciplined forecasting –Consistent cross sector relative value  Risk adjusted –Portfolio optimization and construction –Risk management

4 Common Themes n Full integration of risk management and portfolio management processes n Common process for all products and portfolios –Mass customization? Core, Core Plus, Intermediate, Long, and Structured Products n Both Top-down and Bottom-up

5 Role of Quants in the Organization n Product definition and design n Process definition and tools Design and conceptualize tools to be implemented by IT n Add value by blending smart ideas and quantitative concepts Challenges: n Cultural n Finding people with both quantitative and fundamental strength

6 Cross-Sector Relative Value Process Sector Information - Fundamental - Technical - Valuation Bond Policy - Optimized curve and sector exposures - MAC, IG Corp, HYLD and EMG sector allocation versus normal - Portfolio maps Bond Policy Curve and Swap Spread Forecast - Quantitative tools - Fundamental judgment - Risk/reward reconciliation Risk-Controlled Sector Optimization Bottoms-Up Analyst/Sector Evaluation - Factor Sheets - Analyst rating - Spread forecast Macro Environment - Factors affecting U.S. economic growth (Economic, Monetary, International, Political, Asset Markets) - Economic scenarios and probabilities (GDP, Inflation, FF) Quantitative Cross-Sector Relative Value Tools - Relative Statistics - Volatilities - Relative Z scores and ranges - Cross plots - Market snapshot - Internal and LehmanLive Sector Teams - Optimal implementation plan - Intra-sector relative added-value - Security selection - Monitoring and re-evaluation - Bond policy feedback

7 Sample Product Sources of Added Value

8 Product Definition n Product Templates - Long Term –Tactical –Strategic n Product Maps –Detailed targets per sector/credit/duration bucket –Daily monitoring of absolute and relative Exposures Portfolio vs. Target Portfolio vs. Benchmark n Transparency of Risk/Reward Goals Throughout Organization

9 Quantitative Models n Quantitative models are used to support key decisions and are an integral part of the overall process –Interest and Curve Models Interest rate forecast Curve forecast Treasury hump (20 to 25 year part of the curve) –Swap Spread –Value-at-Risk and Risk-Constrained Optimization –Credit driven scenario models for structured products –Prepayment and credit scoring for ABS securities –Specific and portfolio credit risk models

10 Risk-Constrained Optimization Model n Proprietary model creates robust framework for comparing risk and reward across sectors n Model Objectives: Within the context of forecast scenarios, define maximum-return portfolio subject to acceptable risk levels. –Inputs: Expected yield/spread changes Historical pricing data for sectors Current benchmark structure and portfolio holdings

11 Our Idea of Quandamental TM Fixed Income Investment Process n Research-driven –Highly product focused and designed to deliver n Value-oriented –Flexible relative value framework n Quandamental –Robust quantitative framework to support every major decision n Balanced –No single factor drive overall performance over time