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Chapter 28.docx

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University of Manitoba
Management Info. Systems
MIS 4500
Pourang Irani

Chapter 28: Fixed-Income Portfolio Management—Part 1 See chart p. 7 in book 4. Fixed-Income investment management process: 1. setting investment objectives (and constraints) 2. developing and implementing portfolio strategy 3. monitoring portfolio 4. adjusting portfolio Classification strategies: 1. Pure bond indexing (or fully replication approach): perfectly match benchmark (costly to implement) 2. Enhanced indexing by matching primary risk factors: a. primary matched factors: say level of interest rates, yield curve twists, changes in spreads over treasuries b. by not fully replicating, reduces costs c. can try to enhance return 3. Enhanced Indexing by small risk factor mismatches: increase return by tilting toward sector, quality, term structure, etc.; intended to enhance return only slightly to cover admin 4. Active management by larger risk factor mismatches: active management; deliberately larger mismatches 5. Full-blown active management: aggressive mismatches on duration, sector weights and other Indexing:  benchmark: generally: o market risk: have comparable market risk (maturity and duration) o income risk: comparable assured income streams o credit risk: comparable, diversified and satisfying IPS o liability framework risk: some relation to duration of liabilities if play a role o risk profiles: yield curve changes (shift (90%), twist, other)  matching techniques:  cell matching (or stratified sampling): divide benchmark into representative cells and then match  multifactor model: use set of factors that drive bond returns: o effective duration; convexity adjustment; o key rate duration and PV distribution of CFs:  key rate duration  divide into nonoverlapping periods and match PVs o Sector and quality percent o sector duration contribution: o quality spread duration contribution o sector/coupon/maturity cell weights o issuer exposure (event risk)  Tracking risk: variability w/ which portfolio’s return tracks benchmark index return: standard deviation of active return; active return = portfolio’s return – benchmark index’s return. o tracking risk results from mismatches from: 1. portfolio duration, 2. key rate duration and PV distribution of CFs; 3. sector and quality percent; 4. sector duration contribution; 5. quality spread duration contribution; (and other factors listed under multifactor model technique)  Enhanced Indexing Strategies: o lower cost enhancements: control costs (say competitive bidding) o issue selection enhancements: conduct own credit analysis o yield curve positioning: overweighting undervalued areas of curve and underweighting overvalued areas o Sector and quality positioning:  say tilt toward short-duration corporates  periodic over- or underweighting of sectors o Call exposure positioning: determine probability of call around crossover point Active Strategies: accept large tracking risk:  process: o 1. Identify which index mismatches are to be exploited o 2. Extrapolate market’s expectations (or inputs) from market data o 3. Independently forecast necessary inputs and compare w/ market’s expectations o 4. Estimate relative values of securities in order to identify areas of under- or overvaluation  Total Return Analysis and Scenario Analysis: o total return analysis: assessing expected effect of trade on portfolio’s total return given interest rate forecast 1  Semiannual total return = TotalFutureDollars  1  FullPriceofBond  o scenario analysis: conduct analysis on varied assumptions Monitor/Adjust Portfolio and Performance Managing Funds Against Liabilities:  Dedication Strategies: o Immunization: portfolio over specified horizon that will earn predetermined return regardless of interest rate changes o Cash Flow Matching: provides future funding of liability stream from coupon and matured
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