Fall-02 EMBAF Zvi Wiener Based on Chapter 17 in Fabozzi Bond Markets, Analysis and Strategies Active Bond Portfolio Management Strategies

Zvi WienerFabozzi Ch 17 slide 2 Main Steps 1. Setting investment objectives 2. Establishing investment policy 3. Selecting a portfolio strategy 4. Selecting assets 5. Measuring and evaluating risk and performance

Zvi WienerFabozzi Ch 17 slide 3 Setting Investment Objectives Pension funds Insurance: life, property and causality Banks Mutual funds Money managers Main idea ALM! ALM=Assets-Liabilities Management

Zvi WienerFabozzi Ch 17 slide 4 Establishing Investment Policy Asset allocation Regulatory constraints Tax and reporting implications Credit policy Maximal loss Modern approach: benchmarking! Tracking error

Zvi WienerFabozzi Ch 17 slide 5 Selecting a portfolio strategy Active versus passive strategies Indexing and indexing plus Structured portfolio strategies Immunization Cash flow matching Debt management! Other types of assets: GNMA, callable, etc.

Zvi WienerFabozzi Ch 17 slide 6 Measuring Risk and Performance Relative to benchmark Yield versus volatility Exposure: duration convexity    , 

Zvi WienerFabozzi Ch 17 slide 7 Measuring Risk and Performance VaR = Value-at-Risk RAROC = risk adjusted return on capital Tracking error Historical simulations Stress tests Scenario analysis

Zvi WienerFabozzi Ch 17 slide 8 Active Portfolio Strategies Interest rates expectations strategies Yield curve strategies bullet strategy = concentrated durations barbell strategy = two extreme maturities ladder strategy = uniform distribution Read dollar convexity in ch. 17 Futures and other derivatives are very useful Credit management

Zvi WienerFabozzi Ch 17 slide 9 Debt Management New area! Very little theoretical work is done Various recipes exists For example: government debt, corporate loans, etc. Major problem is to quantify assets.

Zvi WienerFabozzi Ch 17 slide 10 Example X – price = 80, duration = 5 You have $10M notional of bond X. This means $8M market value. If IR will go 1% up, you will lose 5% of market value, i.e. $400,000.

Zvi WienerFabozzi Ch 17 slide 11 Example Y – price = 90, duration = 4 You can exchange your portfolio to bond Y. You will buy $10*8/9 = $8.9M notional of Y Or $8M market value. If IR go 1% up you will lose 4% of $8M = $360,000

Zvi WienerFabozzi Ch 17 slide 12 Advanced Financial Instruments Forwards and Futures Options plain and embedded Swaps – IRS, currency, asset swaps, credit CMO, CLO, CBO, CDO Repos and reverse repos (read ch. 17) Credit derivatives: CLN, credit default swap

Zvi WienerFabozzi Ch 17 slide 13 Repos Repurchase agreement – a sale of a security with a commitment (by the seller) to buy it back (from the purchaser) at a specified price and date. It is a collateralized loan. Interest rate is repo rate $ interest = $ amount * repo rate * term/360 General collateral or special collateral.

Zvi WienerFabozzi Ch 17 slide 14 Ch. 17: Questions 6, 9, 16, 18, 20, 21, 23 May be more questions from Alon. Read materials from major investment banks on the course website. Home Assignment Chapter 17

Zvi WienerFabozzi Ch 17 slide 15 Course summary Fixed income instruments Government and non-government bonds Agencies, municipals, corporate Prices and yields Typical embedded options Term structure of IR Duration, convexity Bond portfolio management

Zvi WienerFabozzi Ch 17 slide 16 TreasuriesInvestment gradeSwap ParSpeculative gradeRating Strips, zerosDurationYield VolatilityConvexity Callable LIBORPuttableCP, CD SpreadImmunizationSwap TIPSFloaterDebenture SecuritizationGNMA, MBACollateral ConvertibleDefault riskYield curve MTNTransition matrixDefault CMO, CDO, CBO, CLO, IRS, repo

Zvi WienerFabozzi Ch 17 slide 17 Exam 11-Dec-02, 15:00-17:00, 4 טבע multiple choice questions No correct answer may be a correct answer! Mark the closest answer Do not lose precision in calculations Write your calculations on the exam If you have specific questions before the exam, please contact me or Alon.

Zvi WienerFabozzi Ch 17 slide 18 Useful Internet Sites This site contains a good source for current rates, the current and past yield curves, and explanations of how the shape of the yield curve can affect economic performance. It also has a summary of current economic factors that are influencing rates. The site listed above has price and yield curve information and the ability to chart Treasury securities over time The site listed above has price and yield curve information and the ability to chart Treasury securities over time. The site listed above has price and yield curve information and the ability to chart Treasury securities over time. Historical information on interest rates and other economic factors are available in the Federal Reserve Economic Data Base (FRED) at the address shown above. Data in FRED can be downloaded in a spreadsheet format.

Zvi WienerFabozzi Ch 17 slide 19 Useful Internet Sites General price information can be found at the site listed above. Detailed information on bonds can be found at this site. It is comprehensive and has many related links Detailed information on bonds can be found at this site. It is comprehensive and has many related links. Rating agencies:

Zvi WienerFabozzi Ch 17 slide 20 Useful Internet Sites

Zvi WienerFabozzi Ch 17 slide 21 Slides from my previous lecture, or swaps, or credit derivatives FRMJorion22CreditDerivatives.ppt

Zvi WienerFabozzi Ch 17 slide 22 Callable Bond non-callable callable Callable bond = noncallable – call option price Negative convexity area yield price

Zvi WienerFabozzi Ch 17 slide 23 Option-Free Bond Price = present value of the cash flow discounted at spot rates. YearsYTMMarket Value 13.5% % %100 YearsSpot rateForward (1y) %3.500% %4.523% %5.580%

Zvi WienerFabozzi Ch 17 slide 24 Option-Free Bond 5.25% coupon bond with 3 years to maturity:

Zvi WienerFabozzi Ch 17 slide 25 r0r0 r 1,H r 1,L r 2,HH r 2,HL r 2,LL r 3,HHH r 3,HHL r 3,HLL r 3,LLL

Zvi WienerFabozzi Ch 17 slide 26 r0r0 r1e2r1e2 r1r1 r2e4r2e4 r3e6r3e6 r2e2r2e2 r2r2 r3e4r3e4 r3e2r3e2 r3r3

Zvi WienerFabozzi Ch 17 slide 27 Note that

Zvi WienerFabozzi Ch 17 slide 28 Option-Adjusted Spread OAS OAS is the spread over the spot rate curve that is due to the embedded options. Modified duration often assumes fixed cashflow. A better measure is option-adjusted or effective duration.

Zvi WienerFabozzi Ch 17 slide 29 Effective Duration P - -price if yield is decreased by  y P + -price if yield is increased by  y P 0 – initial price of the bond

Zvi WienerFabozzi Ch 17 slide 30 Effective Convexity