Carlos Calderon Gonzalez

ECONOMIC ANALYSIS, ASSET ALLOCATION AND FIXED INCOME PORTFOLIO MANAGEMENT

STUDY SESSION 7

Capital Market Expectations

1. Formulating Capital Market Expectations

a. Macro expectations (classes, top down), micro expectations (individual, bottom up)
b. Beta research (systematic risk), alpha research (excess returns)
c. Formulate
i. Determine capital market expectations, tax status, allowable classes, time horizon
ii. Determine drivers with historical performance
iii. Valuation model
iv. Collect best data
v. Interpret current investment conditions
vi. Formulate capital market expectations
vii. Monitor performance
2. Problems in Forecasting
a. Limitation to using economic data
i. Time lag collection and distribution
ii. Revisions
iii. Definitions and methodology changes
b. Data measurement error and biases
i. Transcription errors
ii. Survivorship bias
iii. Appraisal data (smoothed)
iv. Biases downward SD and returns less correlated
c. Limitations of historical estimates
i. Regime changes = nonstationary data
ii. Long time period preferable: statistically required, precise statistical estimates, calculated
statistics are generally less sensitive
iii. Potential problems: regime change, relevant period is too short to be significant, temptation to
use frequent data
d. Ex post data to determine ex ante risk and return
i. Underestimate risk, overestimate returns
e. Uncover patterns
i. Data mining, relationship unlikely to persist
ii. Time period bias: time span chosen
iii. Should: economic basis, modeling process, test out-of-sample data
f. Fail to account for conditioning information
i. Relationship not constant, reflect economic conditions.
g. Misinterpretation of correlations
i. Possible third variable influence both, or nonlinear relationship.
h. Psychological traps
i. Anchoring trap – first info overweighed
ii. Status quo trap – predictions influenced by recent past
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iii. Confirming evidence trap – only supporting the existing belief is considered
iv. Overconfidence trap – past mistakes ignored
v. Prudence trap – overly conservative to avoid the regret form extreme forecasts
vi. Recall ability trap – easiest to remember, overweighed
i. Model and input uncertainty
3. Forecasting Tools
a. Statistical tools
i. Descriptive (summarize), inferential (forecast)
ii. Stationary: historical estimates reasonable estimates
iii. Historical equity risk premium + current bond yield = expected return on equities
iv. Shrinkage estimate: weighted average history and projection
v. Time series models: past valid estimator for future, volatility clustering (high/low vol tens to
persist)
vi. Multifactor models: same set of factors, reduces chance of random variation, allow testing
consistency
b. Discounted cash flow models
i. Advantage: emphasis on CF
ii. Disadvantage: no current market condition, LT valuation
iii. Gordon growth model
iv. Growth rate: adjusted for difference between economy and equity index (excess corporate
growth)
v. Grinold and Kroner, adjusts for stock repurchases and changes in market valuations.
1. Expected income return
2. Expected nominal earning s growth
3. Repricing return
vi. Estimating fixed income returns: YTM = E(R)
c. Risk premium approach
i. Risk premium or buildup model
ii. R = real rf + inflation + default RP + illiquidity RP + maturity RP + Tax RP
d. Financial equilibrium models
i. Supply and demand in balance
ii. ICAPM
1. Relationship between covariance and correlation
2. Beta
3. Combining both
4. Rearranging ICAPM
iii. Singer and Terhaar analysis adjust for market imperfection
1. Illiquidity: multi-period shape ratio period liquid vs. market
2. Segmentation: capital doesn’t flow freely, govt restrictions, investment barriers.
4. Economic Analysis
a. Inventory and business cycle
i. Economic growth = cyclical (ST) + trend (LT)}
ii. Cyclical = inventory cycle (2-4Y) + business cycle (9-11Y)
iii. GDP, output gap, recession
iv. Inventory cycle
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1. Inventory to sales ratio. Increases with business confidence, employment increases and
economic growth
b. Business cycle and asset returns
i. Lower risk premiums: assets higher returns in business cycle lows.

Initial Recovery Early Upswing Late Upswing Slowdown Recession

Few months Several years Few months to 1Y 6M to 1Y
Business confidence Increasing confidence Confidence/ Declining confidence Declining confidence
rising Increasing inventories employment high Falling inventories and profits
Large declines in
inventories
Stimulative policy Less stimulative CB limits growth of Becoming less Easing
policy money supply, restrictive
becoming restrictive
Falling inflation Low inflation Inflation increases Inflation still rising Inflation tops out
Large output gap Output gap is Output gap Increase in
narrowing eliminated, good unemployment and
growth bankruptcies, growth
down
Low/falling ST rates Rising ST rates Rising ST rates ST rates at peak Falling ST rates
Bond yields bottom Bond yields flat/rising Bond yields rising Bond yields peaked Bond yields falling
and falling
Rising stock prices Rising stock prices Rising/peaking stock Falling stock prices Stock prices increase
prices
Cyclical, riskier assets Increasing growth Economy at risk of Yield curve may invert
do well overheating
5. Inflation and Asset Returns

Deflation Inflation at or below Inflation above

expectations expectations
Cash equivalents Negative, 0% interest rate Neutral, stable/declining Positive, increasing yields
yields
Bonds Positive, fixed future cash Neutral, stable/declining Negative, rates increase,
flows yields price decline
Equity Negative, economic activity Positive, predictable growth Negative, some companies
and business decline can do well
Real estate Negative Positive Positive
a. Consumer and business spending
i. Consumer > business spending
ii. Consumer spending: store sales, retail sales, consumer consumption. Seasonal pattern, primary
diver income (NFP, new unemployment claims), savings data
iii. Business spending: more volatile, peak of inventory spending is bearish signal, overspent
relative the amount they are selling
b. Monetary policy
i. Reduce ST rates: grater consumer spending, business spending, higher stock pries, higher bond
prices, lower value of domestic currency
6. The Taylor Rule
a. If inflation is too high, increase ST rates
b. If growth too low, cut ST rates
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c. Fiscal policy
i. Stimulate economy: loose fiscal policy (decreasing taxes, increasing spending, increasing deficit)
ii. Aspects
1. Matters the change, not the level of defict
2. Natural changes in defiti are not policy
7. The Yield Curve

Expansive MP Restrictive MP
Expansive FP YC steep, economy likely to grow YC flat, economy less clear
Restrictive FP YC moderately steep, economy less clear YC inverted, economy likely to contract
8. Economic Growth Trends
a. Long-term trend growth rate (stable in developed, less predictable in emerging)
i. Population growth and demographics
ii. Business investment and productivity
iii. Healthy banking system
iv. Reasonable government policies
v. Shocks: war, accounting scandals, collapses
b. Long-term stability: related with consumer spending
i. Wealth effect: amplify swings in business cycle
ii. Permanent income hypothesis: spending driven by LR income expecations, countercyclical
behavior.
c. Focus: labor, capital, TFP
d. Implications for capital markets
i. High rates in capital investment
ii. Not necessarily linked to favorable equity returns, as its related to return on capital
iii. Structural government policies
1. Sound fiscal policy
a. Twin defict problem: government budget and current account deficits
b. Outcomes: borrowing stop, cutback in spending, currency devalue, print money,
excessive domestic borrowing, detrimental to real growth
2. Minimal government interference in free markets
3. Facilitate competition in private sector
4. Development of infrastructure and human capital
5. Sound tax policies
e. Exogenous shocks
i. Unanticipated events, outside normal course. Not alreddy built in prices
ii. Spread to others: contagion.
iii. Oil, financial crisis,
9. Links Between Economies
a. Macroeconomic links: convergence in business cycle, international trade and capital flows
b. Interest rates and currency exchange rates
i. Pegs: unilateral declaration of pegging to maintain exchange rate. Fluctuate with the markets
confidence in the peg. If lose confidence, increase ST rate to attract capital
ii. Relationship interest rate differentials and currency
1. If overvalued, rates higher to compensate
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2. Relative bond yields increase with strong economic activity an increasing demand for
funds
3. Differences in nominal interest rates reflection of differences in inflation. As real rates
are equal.
10. Emerging Market Economies
a. Charactersitics
i. High returns, higher risk
ii. Require heavy investment in physical and human infrastructure, so foreign borrowing
iii. Unstable poltical and social systems
iv. Lack of a middle class
v. Heavily depnndent on commodities, undivserified nature
vi. Bond investor: credit risk. Euqity investor: gorwh tprospets and risk
b. Questions (unhealthy if)

Responsible fiscal and monetary policies? Deficit/GDP >4% buildup debt >70%
Expected growth? <4%, no govt regulation
Stable, appropriate currency value? Current account deficit >4%
Country too highly levered? Foreign debt of GDP (>50% overlevered, >200% high risk)
Level of FX reserves relative to ST debt? FX reserves < foreign debt paid off in one year
Govt stance regarding structural reform? Supportive to structural reforms, more hospitable for investment
11. Economic Forecasting

Description Advantages Disadvantages

Econometric analysis Incorporates many variables Complex, time-consuming
Can be reused Data forecast difficult
Output is quantified Relationships change
Output requires interpretation
Not well in recessions
Economic indicators Leading, Simple, intuitive, easy Inconsistent forecast
composite, Data available False signals
diffusion Can be tailored
Academic support
Checklist approach Judgement Less complex Subjective
required Flexible Time-consuming
Complexity must be limited
12. Economic Conditions and Asset class Returns

Cash instruments If rates set to rise, reduce term. IF economy improve, lower-rated instruments
Credit rf bonds ST horizon: cyclical changes economy and changes in ST r
Higher growth = greater demand, higher inflation = higher yields
Change in ST rate = increase rates, but may fall if slowdown economy
Credit risky bonds Recession: credit risk premium increases, default more likely, CP dries up, higher yields
Emerging market govt bonds Hard currency, higher default risk
Inflation-Indexed bonds Yield rises as real economy expands
Falls as inflation accelerates
Changes with supply and demand
Common Stock Earnings depend on growth. ST growth affected by business cycle.
Noncyclical / defensive stocks: less affected, lower risk premiums and higher valuation
Stock valuation: P/E, higher in early expansion, with ow inflation results, expecting to
recover.
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Emerging market stocks Positively correlated with business cycles in developed world - Trade and capital flows
Real Estate Affected by interest rates, inflation , shape of Y and consumption. Interest rates affect
demand and supply.
13. Forecasting Exchange rates
a. Supply and demand, tradef and capital flows.
b. Methods of forecasting

Purchasing power parity (PPP) Differences in inflation reflected in exchange rate. Higher inflation will see currency
value decline. Holds LT (>5Y)
Relative Economic Strength Favorable investment climate, increase currency’s value. High ST rates attract investors
Capital flows approach LT capital flows. Complicates relationship between ST rates and currency value, cu
might promote growth.
Savings investment Why currencies diverge form equilibrium for extended periods.
imbalances I>S, capital must flow to finance. To attract capital domestic currency must increase
Equity Market Valuation

1. Cobb-Douglas Production Function

Cobb Douglas

Changes in real economic output

Solow residual

a. Changes in TFP (rate of managerial and technological innovation)

i. technology
ii. restriction on capital flow, labor mobility
iii. trade restrictions
iv. laws
v. division of labor
vi. depleting/discovering natural resources
b. Factors on economic growth (growth increases if)
i. Increase savings rate
ii. Increase population growth rate
iii. Increase labor force participation rate
iv. Decreases environmental, pollution, controls and regulation
v. Decreases reform measures
c. Countries
i. Developed:
1. Corporate share relatively stable. Dividend and economic growth closely tied.
2. LT trend more stable GGM
3. Risk more predictable and stable
ii. Less developed
1. Economic data less available and reliable
2. Link economic and corporate less direct (structural and governmental chagnes9
3. Dramatic change in inflation, disrupt valuation input estimates
d. Models
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GGM

H-model

i. Preference to use real values

1. Cobb Douglas: real growth rate
2. Inflation fluctuates over time and varies between countries.
3. Real inputs more stable, easier to estimate
ii. Variations on DDM approaches
1. Facilitate comparison: justified P/E ratio
2. GGM: can be solve for implied growth rate or r
a. Growth will be higher/lower than implied growth, so market is under/overvalue
b. Implied r is higher/lower than appropriate, market is under/overvalue
2. Forecasts
a. Top-down forecast: macro factors, estimate performance, identifying sectors. Compare relative values
of composites, identify momentum
i.
b. Bottom-up forecast: first micro perspective, fundamentals of individual firms. Assess management
willingness and ability to adopt technology to grow. CF, firms’ investment potential, aggregate into
sector and asset class returns, compared to top-down estimates.
i. If long-short, market-neutral strategy
3. Estimating Market Earnings per share (EPS)
a. Reasons for different results
i. Models used in a top-down analysis
ii. Manager bias in bottom-up. Tend to be more optimistic in recession, and more pessimistic in
recovering.
4. Relative equity market valuation
a. Relative value models:

Fed model S&P earnings yield / 10Y treasury yield

IF >1, index value is too low relative to earnings, equities are undervalue.
Criticism: ignores equity risk premium, ignores earnings growth, compares real with nominal variable
Spread analysis: if above LT average, is historically high, equity prices expected to increase.
Yardeni model Equilibrium earnings yield P0=E1/(r-g), E1/P0=r-g,
Incorporates risk: difference between the yields on A rate corporate and rf (equity risk premium), and
use LTEG (LT earnings growth)
E/P=Y-d(LTEG)
Compared to the market earnings yield.
Considerations: incorporate proxy of equity risk premium, measure of default risk (not equity risk),
estimate value investors place on earnings growth, LTEG might not be an accurate estimate of LT
growth
10Y MA P/MA(E), numerator is market price of S&P, denominator average of 10Y of reported real earnings.
price/earnings Both adjusted by inflation using CPI.
model Restated(E)=Nomina(E)*CPI(2010)/CPI(2008)
Considerations: restating P according CPI, 10Y earnings captures business cycles, sometimes current or
expected earnings more useful, not consider changes in accounting rules or methods. Ratios have
persisted.
b. Asset-based models
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i. Tobins q = (asset market value)/(asset replacement cost)=(MV of debt+equity)/(ARC)
ii. Equity q= (MV of equity)/(replacement value of net worth)=(#shares*P)/(replacement value of
assets-liabilities)
iii. Neutral value = 1, are mean reverting, expected P correction may not occur quickly

STUDY SESSION 8

Introduction to Asset Allocation

1. Investment Governance
a. Ensures informed decisions, oversight, improve performance
b. Effective investment governance models
i. LT and ST objectives
1. Pension fund (Assets=Liabilities), Endowment (rate>required), Individual (retirement)
2. Return requirement, willingness/ability to tolerate risk, obligations, liquidity
ii. Rights and responsibilities
1. Depends on size, internal staff, knowledge, skills and abilities. Resource availability
iii. IPS
1. Investor characteristics, objectives, willingness to accept risk, constraints, duties,
allocation rights and responsibilities, guidelines: asset types.
iv. Strategic asset allocation
1. IPs, time horizon, risk/return asset allocations, specify rebalancing
v. Reporting framework to monitor
1. Evaluate performance, guideline compliance, program’s progress, current status
vi. Governance audit
1. Third party, minimize decision-reversal risk, provide durability evaluating turnover.
2. Economic Balance Sheet (EBS)
a. EBS: financial and non-financial assets and liabilities
b. Extended portfolio A/L: PV of expected earnings (Human Capital), PV of pension income, PV of expected
intellectual royalties, PV of expected consumption, PV of foundations payouts
c. Life-cycle balanced fund: changing levels of human and financial capital.
3. Asset Allocation Approaches

Asset-only Liability-relative Goals-based

Def Mean-Variance Optimization Surplus optimization Sub portfolios with stated goals: specify
(MVO), Max Sharpe Matching duration and PV of type of CF needed
liabilities of institutional investors Based on meeting liabilities of individual
Liability-driven investing investors. Meet specific lifestyle goals
Investor goals much less predictable.
Risk SD, Vol, Corr, relative risk (TE), Vol of contributions Not able to achieve goals
downside risk (VaR, SD of surplus Weighted sum of risk attached to each
semivariance, max drawdown). Differences between A/L goal
Complement: Monte Carlo
4. Asset Classes
a. Similar investment characteristics, own quantifiable systematic risk
b. Super Asset Classes
i. Capital assets (continuous source of value)
ii. Consumable/transformable assets (can be transformed into a source of value)
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iii. Store-of-value assets (value when sold)
c. Criteria to specify classes
i. Within asset class: similar descriptive and statistical attributes
ii. Between asset classes: no highly correlated
iii. Cannot be classified in more than one class
iv. Cover all possible investable assets
v. Contain sufficiently large percentage of liquid assets
d. Too much granularity = difficult to construct portfolio.
5. Common Risk Factors
a. Asset-based allocation problematic: overlapping risk factors
b. Factor-based allocations focus on risk factors.
6. Strategic Asset Allocation
a. Combines capital market expectations with IPS. LT in nature. Max U, s.a. cosntraints.
b. Steps
i. Objectives
ii. Tolerance for risk
iii. Time horizon
iv. Constraints
v. Allocation approach
vi. Asset Classes
vii. Potential asset allocations
viii. Simulate results
ix. Find optimal allocation
7. Tactical Asset Allocation
a. Active management, take advantage of St opportunities
b. Introduces additional risk, seeking additional return.
c. Restricted by risk budegets or rebalancing ranges.
d. Based on forecasted asset class valuation, business cycle, or momentum
e. Dynamic asset allocation (DAA): performance in one period affects others.
8. Global Market Portfolio
a. Contains all available risy assets in proportion of total Market value
b. Minimizes diversifiable risk, most diversified portfolio.
c. Good starting point, then adjusted IPS
d. Proxy: such as ETFs
9. Strategic Implementation Choices
a. Asset Class weights and allocation
i. Passive: indexing, low-cost means of investing
ii. Active: insights or expectations
iii. Decision active/passive spectrum depends on:
1. Availability
2. Active management scalability
3. Investor constraints
4. Belief in efficient markets
5. Cost-benefit tradeoff
6. Tax status
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b. Risk budgeting
i. Measuring risk: SD, VaR, relative of absolute terms, money or % terms
ii. How much additional risk willing to take relative to benchmark
10. Rebalancing
a. SAA: specified range of percentages, if out, rebalanced is triggered.
b. Benefits: maintain desired exposure, provides discipline.
c. Cost of no rebalancing: failure to realize the gains form temporarily overvalued securities.
d. Rebalancing approaches
i. Calendar rebalancing: regular basis, frequency depends on volatility of portfolio, benefit =
discipline without constant monitoring.
ii. Percentage-range rebalancing: triggered by changes in value rather than calendar dates,
minimizing degree to which asset classes violate allocation corridors.
e. Strategic considerations for corridor width
i. Higher transaction costs: wider corridors
ii. Higher risk tolerance, wider corridors
iii. Higher correlations: wider corridors
iv. Momentum: current trends will continue, wider corridors
v. Liquidity: lager trading costs, wider corridors
vi. Derivatives: overlay to synthetically rebalance portfolio, lower transaction costs lower taxes,
executed quicker and easier, tradeoff: additional risk management
vii. Taxes: taxable portfolios, wider corridros
viii. Higher Volatility, tighter corridor

Principles to Asset Allocation

1. Mean-variance optimization
a. Diversified portfolio requires: asset allocation decision, implementation decision
b. Efficient frontier with subset of suitable assets
c. No assumes rf asset exists
d. U= E(Rm)-0.005*lambda*Varm
i. Lambda= preference for trading risk and return, unique to individual(1-10, av. 4, risk averse)
ii. Um =certainty-equivalent return.
iii. Constraints
1. Budget constraints Sum(w)=1
2. Non-negativity constraint 0<=w<=1
e. Criticism
i. GIGO: garbage-in-garbage-out
ii. Concentrated asset class allocations
iii. Skewness and kurtosis
iv. Risk diversification only for classes, not for sources of risk
v. Ignores liabilities
vi. Single-period framework
2. Address first 2 criticism (last one 3)
a. Improving quality of inputs
i. Reverse optimization
1. Assume optimal portfolio weighs, derivate returns, then MVO
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2. Assume world market portfolio as starting point
3. Advantage: derived returns reflect diversified portfolio
ii. Black-Litterman model (extension)
1. Adjusted to reflect investors unique view
b. Adding more constraints (if too much not really optimizing)
i. Fixed allocation to assets
ii. Allocation range for asset class
iii. Upper limit to address liquidity issues
iv. Relative allocation between two or more classes
v. Liability-relative setting
c. Resampled MVO
i. MVO, Monte Carlo, Resampled efficient frontier as average of simulated frontiers
ii. Address limitation of MVO and help to identify risk tolerance level
d. Non-Normal distribution (Skewness and Kurtosis)
i. Include them in utility unction
ii. Use asymmetric definition of risk: VaR
3. Other adjustments
a. CF of human capital = inflation linked bond
b. Less certain and more volatile future wages = inflation linked bond + corporate bond
c. As human capital is not tradable, % allocation is fixed
d. Residential real state: real estate property index, allocation constrained to current value
4. Asset class liquidity
a. Less liquid asset classes, with liquidity premium difficult to include
i. Few indexes available
ii. Generally not investable as a passive alternative
b. To address this
i. Exclude illiquid asset
ii. Include illiquid asset and model the inputs of the specific investments you plan to use
iii. Include illiquid asset using highly diversified inputs, recognizing that actual investment may have
different characteristics
5. Risk budgets
a. Marginal contribution to portfolio risk (MCTR) = change in total portfolio risk for small change in asset
allocation to a specific asset class
i. See what happens with portfolio risk with changes in allocations
ii. Identify optimal allocations
iii. Develop risk budget
iv. MCTRi=Bi * SDp (Bi=beta asset classi with portfolio)
b. Absolute contribution to total risk (ACTR)
i. ACTRi = wi*MCTRi
c. %risk contributed = ACTRi/SDp
d. Optimal allocation: excess return/MCTR = in all asset classes = Sharpe
6. Incorporate clients risk preference
a. Additional cosntaitns
b. Risk aversion factor
c. MCS illustrate outcomes
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7. Investment factors
a. Examples: market exposure, size, valuation, momentum, liquidity, duration, credit, volatility
b. Consistent with fundamental factor return models.
c. Factor are not highly correlated with each other
d. Resulting efficient frontiers form factors or asset classes are equal. Choice depends on how you form
capital market expectations
8. Liability-relative asset allocation (Pnesion liability)
a. Plan surplus = Market value of assets – PV of liabilities
b. Funding ratio = market value of assets/PV of liabilities
c. Value of assets and liabilities are driven of some of the same factors
9. Characteristics of liabilities
a. Fixed vs. contingent
b. Legal vs quasi legal
c. Duration and convexity
d. Liability value vs. size of sponsoring organization
e. Factors that affect future CF
f. Timing considerations, longevity risk
g. Regulations
10. Approaches to liability-relative asset allocation
a. Surplus optimization
i. Extension of MVO
ii. Rs,m=surplus return = ch(asset value)-ch(liability value)
iii. Um=E(Rs,m-0.005*lambda*Vars,m)
iv. Correlations reflect usefulness of assets to hedge liabilities.
v. Estimate R and Var of liabilities
1. Assumption = corporate bonds
2. Factor approach = common factors with assets
b. Two portfolio approach
i. Subportfolios: hedging and return-seeking
ii. Hedging: CF matching, duration matching or immunization
iii. Modifications for higher expecting returns.
1. Partially hedging, more capital to return-seeking
2. Increasing allocation for hedging as funding ratio increase
iv. Limitations:
1. If funding ratio<1, difficult to create a hedging portfolio
2. Hedging portfolio may not be available.
c. Integrated asset-liability approach
i. Joint optimization method
ii. Feedback loop, multiperiod model
iii. Banks to identify optimal mix A/L ot meet return and risk objectives
11. Goals-based approach
a. N of objectives, different time horizons and levels of urgency (specified required prob of success)
b. Subportoflios: each goal address individually, minimum expectations for each goal
c. Differences in risk/return, liquidity, asset classes.
d. Highest expected return with specified prob of success over time horizon
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e. Size = PV of future goal discounted at expected return
12. Heuristic / ad hoc approaches of allocation
a. 120 – Age (go to Fixed-income, as value of human capital declines as we age)
b. 60/40 split (stock/fixed income)
c. Endowment Model or Yale Model (larger amounts of alternative investment, less-than perfectly
informationally efficient, capacity to outperform, popular for university endowment funds)
d. Risk parity (diversification each asset class contributes the same amount to the total portfolio risk, focus
on risk not return)
e. 1/N rule (rebalance to equally weighted each quarter)

STUDY SESSION 9

Asset Allocation with Real-World Constraints

1. Additional constraints when choosing and optimal asset allocation

a. Asset size
i. Smaller fund: lack expertise and governance to invest in complex strategies, problem of
diversification = commingled investment accounts.
ii. Larger portfolio: greater expertise, compelx strategies, larger capital base, high minimum
investment requirements, higher diversification. Eonosmies fo scale, higher allcoations to
alternative investments. But may not be able to take advantage in low capacity asset classes. Ma
take passive approach
iii. Very large funds: not enough alternative investmetns. Fund-of-funds
b. Liquidity needs
i. Consider possibility of extreme market conditions
ii. Depends on type of fund

Portfolio owner Typical liquidity needs

Banks High liquidity
Sovg, wealth funds, endowments, pension funds, foundations Long time horizon, lower liquidity
Property and casualty insurance High, unpredictability of claims
Life, auto insurance Low, predictability of claims
Individuals Varies by circumstance
c. Time horizon
i. Defined by liability or goal
ii. Changes in A/L also requires changes in asset allocation
iii. Associated with ability to take risk (time diversification)
2. Regulatory and other external constraints
a. Insurance companies
i. Largest allocation in Fixed income, match assets to CF
ii. Main risk considerations
1. Risk-based capital measures
2. Liquidity
3. Yield levels
4. Credit ratings
5. Potential to liquidate assets
iii. Equity investment limited: caps for private equity and High Yield
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b. Pension Funds
i. Tax, accounting, reporting and funding constraints
ii. Tax incentives to Invest in domestic assets
iii. May allow deferred recognition of losses
iv. Consider anticipated funding cost
v. Risk of funding cost > threshold vs. PV of expected contributions
c. Endowments and foundations
i. Infinite time horizon, risky assets
ii. Very few regulatory constraints
iii. Minimum required distribution or socially responsible investment, maintain tax-exempt status
iv. Covenants may constrain
d. Sovereign wealth funds
i. Govt-owned entities
ii. Not match assets liabilities but Subject to scrutiny
iii. Constraints: minimum investment in socially or ethically acceptable, max investment in risky
assets, limits on currencies
iv. Goals: environmental, social and governance
3. Tax considerations
a. Taxable entities consider after-tax characteristics
i. Tax interest income > tax dividends, capital gains.
ii. Capital losses can offset capital gains
iii. Accounts tax deferred or tax exempt, least tax-efficient placed in the most tax-advantage
account.
b. Taxes complicate optimization process, correlations unaffected
c. Cost basis vs. market value
i. If cost basis < market value = unrealized gain, embedded tax liability
ii. if cost basis > market value = unrealized loss, embedded tax asset
iii. adjust market value
1. sold today and subtract embedded capital gains tax
2. sold in the future and PV(tax liability) using after-tax return
3. sold in the future and PV(tax liability) using rf
iv. adjust risk
d. Portfolio rebalancing
i. Balance need to maintain SAA vs. desire to avoid taxable gains
ii. So rebalancing less frequently with taxable portfolios due to reduction in volatility
iii. After tax deviation = pre tax deviation / (1-t)
e. Strategies to reduce impact of taxation
i. Tax loss harvesting
1. Realizing losses to offset gains
ii. Strategic asset location
1. Most efficient use of tax advantageous accounts
2. Optimization consider: asset classes and asset location
3. Accounts
a. Tax exempt: no adjustemtns
b. Tax deferred: reduce by tax burden, pre-tax
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c. Taxable: after-tax
4. Rules
a. Assets with lowest tax rate: taxable accounts
b. Frequent trading and high tx rates: tax advantaged accounts
4. Revisions to asset allocation
a. Change in goals: business cycle, personal circumstances
b. Change in constraints: govt regulations, large unexpected CF, increased funding requirements, forced
early retirement
c. Change in beliefs: change of committee, economic environment, macro forecasts, predetermined
change (glide path shift form equity to more conservative as target date approaches)
5. ST shifts (TAAs, take advantage of cyclical conditions or mispricing)
a. Objective: increase risk-adjusted returns, exploiting ST opportunities. Take into account risk constraint,
no specific goals or liabilities
b. Constraints: deviations limited, allowable range or TE budget
c. Evaluation: Sharpe ratios, information ratio, realized risk and return, perform attribution
d. Drawbacks: additional trading costs and taxation, risk concentration, less diversification
e. Approaches to Tactical assets allocations
i. Discretionary
1. Qualitative interpretation of macro variables
2. Forecasting ST devaitions form expected return
3. Based on
a. Macro data
b. Fundamental data
c. Sentiment indicators
4. Market sentiment
a. Margin borrowing, increasing pruchases = bullish, too high = bearish
b. Short interest, increasing SI = bearish, too high = bullish
c. Volatility index, level of fear, bid-ask spread or index options, >puts increases,
>calls decreases.
ii. Systematic
1. Value approach
a. Exploit excess return value – growth stocks
b. Shillers earning yield (E/P), 10Y average inflation-adjusted earnings / market P
c. Currencies: ST interest rate differentials
d. Commodities: roll yields (bckwardation, positive roll yields; contango, negative)
e. Fixed income: yield spreads over rf
2. Momentum strategy
a. Most recent 12M trend
b. MA crossover (ST cross above LT = uptrend
6. Behavioral biases
a. Loss aversion: dislike losses > like gains. Helpful: goals-based
b. Illusion of control: overestimate ability to control. Problem: no diversify, too frequent trading. Helpful:
CAPM as starting point. Signs:
i. Frequent trading
ii. Active security selection
Carlos Calderon Gonzalez
iii. Above average short selling and leverage
iv. Shifting allocations despite lack of consensus
v. Concentrated positions
vi. Biased risk and return forecasts
c. Mental accounting: buckets on subjective criteria, suboptimal allocation. Helpful: Goals-based
d. Representative bias (recency bias): more importance to recent data. Helpful: governance, objective AA
e. Framing bias: way presented affects decision. Helpful: downside risk measures, VaR, Cond VaR, shortfall
prob; full range of info
f. Availability bias: experience easily recalled.
i. Familiarity bias: familiar or easy to recall
ii. Home bias: over allocate domestic securities
7. Investment governance
a. Essential to keeping behavioral biases under control
b. Clear LT, ST objective
c. Allocation of responsibility
d. IPS
e. Document SAA
f. Framework to monitor /report performance
g. Periodic audits

Currency Management: An Introduction

1. Introduction
a. Base currency: denominator price in terms of the numerator. Buy and sell refer to base currency
b. Bid/asked rules: smaller number first.
c. Spot vs. fwd: spot = immediate settle, fwd= date for delayed settle, forward quote directly on in points.
(depends on how spot is quoted)
d. Offsetting transactions and mark to market: Mark the position to market value, PV(gain/loss), offsetting
contract position.
e. FX swap: rolls over a maturing fwd contract using a spot transaction into a new fwd contract.
f. Currency option basics call on one currency is put on the other

The call option to buy the base currency The put option to sell the base currency
From 0 to X OTM rising in value. 0 to 0.5 ITM falling in value. -1 to -0.5
On X ATM, delta=0.5 ATM, delta=-0.5
From X, upward ITM, rising in value. 0.5 to 1 OTM falling in value -0.5 to 0
2. Effects of currency on portfolio risk and return
a. Concepts
i. Domestic currency: currency of the investor
ii. Domestic asset: denominated in domestic currency
iii. Foreign currency: foreign asset in other currency
iv. Foreign-currency return: return measured in foreign currency R(FC)
v. %change in value of foregin currency R(FX)
b. Foreign asset priced in a foreign currency have two sources of risk
i. R(FX)
ii. R(FC)
iii. So: R(DC)=(1+R(FC))*(1+R(FX))-1 = R(FC)+R(FX)+R(FC)*R(FX)
Carlos Calderon Gonzalez
3. Calculating portfolio return for multiple investments in foreign assets
a. R(DC)=sum(wi*R(DCi))
4. Risk
a. Two sources of risk

b. Correlation also matters.

i. If positive: returns are amplified, increasing vol
ii. If negative: returns are dampened, decreasing vol
5. Strategic Decisions
a. Not hedging currency risk
i. Avoid time and cost of hedging
ii. In the LT: currencies revert to theoretical value
b. Active management
i. ST, currency movement can be extreme
ii. inefficient pricing of currencies can be exploited
c. Currency management strategies
i. Passive hedging: rule based, matches the portfolios currency exposure that of the benchmark.
Required periodic rebalancing
ii. Discretionary hedging: deviate modestly, reduce currency risk allowing modest incremental
returns
iii. Active currency management: greater deviations, goal is create alpha
iv. Currency overlay: outsourcing of currency management, treat currency as an asset class. Purely
currency alpha.
d. IPS:
i. Hedge or not to hedge:
1. Investor objectives
2. Time horizon
3. Liquidity needs
4. Benchmark
ii. Should specify
1. Target percentage of exposure
2. Allowable discretion
3. Frequency of rebalancing
4. Benchmarks
5. Allowable hedging tools
e. Strategic diversification issues
i. LT: currency volatility lower than ST, less need to hedge
ii. Positive correlations R(FC) and R(FX) increase volatility, need to hedge.
Carlos Calderon Gonzalez
iii. Correlation: vary by time period, diversification in some periods, varying hedge ratio
iv. Higher positive correlation in bond portfolios than equity. MO reason to hedge bond portfolios.
v. Hedge ratio varies by manager preference
f. Strategic cost issues
i. Bid/asked transaction
ii. Options to hedge: upfront option premium cost
iii. Fwd currency term < hedging period. Contracts must be rolled over, can create CF vol.
iv. Overhead costs can be high
v. 100% hedging has an opportunity cost. Split the difference with a 50% hedge ratio
vi. Hedging every currency is costly, partly hedges
g. Factors affect decision
i. ST horizon
ii. High risk aversion
iii. Unconcern to opportunity costs
iv. High ST income / liquidity needs
v. Significant FX bond exposure
vi. Low hedging costs
vii. Doubt the benefits of discretionary management.
6. Tactical Currency management
a. Economic fundamentals
i. Assumes LT currency will converge to fair value
ii. Purchasing power parity (PPP)
iii. Factors will impact path. Increase in value:
1. Fundamentally undervalue
2. Greatest rate of increase
3. Higher real or nominal interest rates
4. Lower inflation
5. Decreasing risk premiums
b. Technical analysis
i. Principals
1. Past price = predict future price.
2. Fallible human, react to similar events in similar ways
3. Unnecessary to know worth of currency, only necessary where it will trade.
ii. Works better in markets with tredns.
1. Overbought / oversold
2. Support/resistance level: sticky price, if move can accelerate
3. Moving averages: ST cross above LT, buy signal
c. The carry trade
i. Borrowing in a lower interest rate (developed, funding currencies), invest in a high interest rate
currency (emerging, investing currencies)
1. Profitable in normal market conditions
2. In periods of financial distress = significant losses
3. When exit carry trade = FX vol increases
ii. Issues
1. Covered interest rate parity (CIRP) hold by arbitrage.
Carlos Calderon Gonzalez
a. Currency with higher rate = forward discount
b. Currency with low rate = forward premium
2. Violation of uncovered interest rate parity (UCIRP): this is an unbiased estimate of the
spot in the future.
3. Trading the fwd rate bias
a. Higher interest rate currency depreciates less than predicted.
b. Small percentage depreciate substantially and generate great losses
d. Changes in factors affect tactical trading

Action
Relative currency Appreciate Reduce hedge, increase long position
Depreciate Increase hedge, decrease long position
Volatility Rising Long straddle (buy ATM put and call = buying vol) or strangle (moderate payoffs,
require larger movement in the currency, cost less)
Falling Short straddle or strangle
Market conditions Stable A carry trade
Crisis Discontinue carry trade.
e. Subtle variations
i. Carry trade with bundle of funding, not equally weighted
ii. Delta neutral position: tilted to net + or – based on managers view
7. Currency management tools
a. Currency exposure needs to be hedge?
b. Easier if quote with foreign bas currency
c. Statements or directions refer to base currency.
d. Buying or selling base currency
e. Hedging is not free
i. Fwds: no initial cost, high opportunity cost
ii. Options: high initial cost, retains upside
iii. Lowering the cost of the hedge: less downside protection or upside potential
1. Writing options
2. Adjusting strike
3. Adjusting sixe
4. Exotic features
f. Discretionary hedging: deviate from policy neutral hedge, increase risk underperformance
g. IPS: define strategic, policy natural hedge position
h. Fwd are preferred
i. Customized
ii. Available for any currency pair
iii. Future contracts require margin
iv. Trading volume, better liquidity
i. Static (held to maturity) or dynamic hedge (rebalance). Choice depend
i. ST contracts or dynamic hedges with more frequent rebalancing: increase costs but improve
hedge results
ii. Higher risk aversion: more frequent rebalancing
iii. Lower risk aversion: strong manager views
j. Mismatch FX swap, near spot leg and far fwd leg not equal size
8. Roll yield
Carlos Calderon Gonzalez
a. Return form movement of the fwd price over time toward the spot price
b. Produces profit/loss
i. Fwd premium or discount
ii. Purchase or sold
c. Roll yield (held to expiration) = (initial fwd – spot ptrice) / initial spot
d. Will affect cost/benfit analysis. Is a cost of hedging
i. Positive roll yield: prefer hedging.

Hedge requires F>S ib<ip F<S ib>ip

Long fwd position Negative roll yield Positive roll yield
Short fwd postion Positive roll yield Negative roll yield
9. Strategies to modify risk and lower hedging costs
a. Reduce hedging costs
i. Increase size of trades: positive roll yield, reduce for negative roll yields
ii. Discretionary or option baed hedging strategies
b. Ways to hedge
i. Over or under hedge with fwd contracts
ii. Buy ATM put options: asymmetric protection, eliminate downside risk, retain upside potential,
expensive
iii. Buy OTM put options: less expensive, reduce initial cost, but does not eliminate downside risk
iv. Collar: buy OTM put (downside protection, costing less), sell OTM (removes some upside
potential, generate premium to reduce initial cost)
v. Put spread: buy OTM puts, sell puts further out of the money. Downside protection but ill a
point. Reduces initial cost.
vi. Seagull spread: put spread combined with selling a call, limits upside potential
c. Exotic options
i. Knock-in: comes into existence in a level
ii. Knock-out: ceases to exist in a level
iii. Binary or digital: does not vary with difference with price and strike
10. Hedging multiple currencies
a. Direct hedge
i. Fwd hedge
b. Indirect hedge
i. Cross hedge: hedging with an instrument not perfectly correlated with the exposure, can
improve efficiency of hedging.
1. Additional risk, imperfect, residual risk increases
2. Historical correlation no guarantee of future
ii. Macro hedge: portfolio-wide risk factors
1. Bond futures (interest risk)
2. Credit derivatives (credit risk)
3. Volatility trading (vol risk)
4. If currency basket: less costly, accepting residual currency risk vs. lower cost
c. Jointly optimize
i. Minimum-variance hedge ratio (MVHR)
1. Regression of past changes of portfolio with hedging instrument to minimize TE. Hedge
ratio is beta.
Carlos Calderon Gonzalez
2. If strong positive correlation RFX y RFC, increase vol RDC, hedge ratio >1
11. Managing emerging market currency
a. Challenges:
i. Higher transaction costs, high markups
ii. Increase prob of extreme events
b. Examples
i. Low trading volume, larger bid/ask, tend to increase in crisis
ii. Lower liquidity, higher transaction cost to exit trades, Gradually accumulate long positions in
higher yield. Crisis =disrupting trading activity
iii. Between two emerging currencies: more costly
iv. Return distributions are non-normal: higher prob of extreme events (negative skew)
v. Higher yield of emerging, large fwd discounts, negative roll yield
vi. Contagion is common, diversification disappears
vii. Tail risk: govt of emerging markets actively intervene in currencies. Long periods of artificial
price stability, so sharp price movements
c. Non-deliverable fwds:
i. Central banks: restrict movement of their currency.
ii. Require cash settlement of gains/losses in a developed market currency
iii. Benefit: lower credit risk
iv. Emerging market govt is restricting currency markets

Market Indexes and Benchmarks

1. Benchmark
a. Reference point, evaluate performance
b. Valid:
i. Specified in advance
ii. Appropriate
iii. Measurable
iv. Unambiguous
v. Reflective of the mangers current investment opinions
vi. Accountable
vii. Investable
c. Investment uses of benchmarks
i. Reference point
ii. Communication
iii. How the manger wishes to be viewed
iv. Clearly specifying risk exposures
v. Performance attribution
vi. Manager selection
vii. Marketing
viii. Compliance, laws and regulations
d. Types of benchmarks
i. Asset-based benchmarks (focus on return of assets)
1. Absolute return: minimum return or spread
2. Manager universe or peer group: outperform the median manager
Carlos Calderon Gonzalez
3. Broad market index
4. Investment style
5. Factor-based models: set weight of factors
6. Return-based: factor are subgroups of asset returns and sensitivities
7. Custom: reflect managers style
ii. Liability based benchmarks (objective: fund payments at low risk)
2. Index
a. Performance of a group of securities
b. Use of market indexes
i. Asset allocation proxies
ii. Investment management mandates
iii. Performance benchmarks
iv. Portfolio analysis
v. Gauging market sentiment
vi. As an investment
c. Index construction (rules)
i. Completeness vs. investability
1. Include all securities: complete coverage and diversification, but inclusion of smaller cap
and less liquid securities
ii. Reconstitution and rebalance frequency vs. turnover
1. Reconstitution: adding/deleting securities, rebalancing: adjusting weighting
2. Frequent better reflects characteristics, but increased turnover and transaction costs
iii. Objective and transparent rules vs. judgement
d. Pros and cons of approaches to index weighting

Capitalization weighted Price-weighted Equal-weighted

Definition Most common. Sometimes free One share of each stock. Same initial investment in each
float is used and shares that are Influence by higher price stock security
not available are excluded
Advantages Objective measure Easy More emphasis on smaller cap
Macro consistent Long price histories available (return an diversficiation)
Only efficient portfolio of risky Better reflects market: average
assets return
No rebalancing for splits or
dividends
Disadvantages Exposed to market bubbles Market cap better reflects eco Biased to smaller issuers
Can lead to overconcentration Split diminishes impact, reduces Require constant rebalancing
May be unsuited weight on most successful Increased liquidity problems and
companies higher transaction costs
NO refelect typical cosntruction
e. Cap weighted, float adjusted dominates
i. Widely used, understood, available, easy, unambiguous, specified in advance, investable,
appropriate if reflects manager style
ii. No reflect manager approach, rules and rebalancing process not transparent

STUDY SESSION 10

Introduction to Fixed-Income Portfolio Management

Carlos Calderon Gonzalez
1. The roles of fixed income in the portfolio
a. Largest segment in financial markets
b. Fixed income may provide
i. Diversification:
1. Low correlation with equity. Correlations are not stable over time.
2. Different correlations between: Investment grade (IG) US, international, high yield and
emerging fixed income.
3. In general bonds have lower standard deviation than equity but may increase during
market crises.
ii. Regular Cash Flow
1. Buy-and-hold laddered portfolio: provide regular cash flow.
iii. Inflation hedge
1. Inflation-linked: direct protection, both coupon and par are protected
2. Floating-coupon: no adjustment to par, coupons are inflation protected
2. Fixed-income mandates
a. Liability based strategies (1 lowest o 4 highest)

Definition Initial funding Risk and Expected realized

required complexity return if successful
Cash-Flow matching 3 1 1
Horizon matching ST: CF match 2 2 2
LT: duration match
Duration matching 1 3 3
Contingent PVA > PVL, surplus>0 managed 4 4 4
immunization If surplus=0, immediately immunized
b. Total return mandates
i. Target an absolute return or seek to outperform an index.
ii. key metrics: alpha, tracking error

Pure indexing Replicate bond index, exactly match all risk factors, allowing security selection
Enhanced indexing Additional flexibility, add active return. Duration still matched to index (<50bp)
Active management Much larger deviations, seeks greater act return (>50bp)
3. Bond liquidity
a. Liquidity: ability to make transactions in large size, quickly in with minimal deviation.
b. Issues leading to illiquidity
i. Large number of issues
ii. OTC, find counterparty, transaction less transparent
c. Less liquid issues: trade at higher yield, liquidity premium
d. Varies by subsector
i. On-the-run high-quality sovg govt: high, decline somewhat for off-the-run
ii. Corporate bond, declines with lower quality (as riskier and smaller size)
e. Effects of liquidity on bond portfolio management
i. Pricing data: infrequent trading = out-of-date trade prices, so matrix pricing
ii. Portfolio construction: buy-and-hold, less need for liquidity, so select in exchange of higher yield.
iii. Less liquid bonds: higher bid-ask spreads
f. Alternatives to direct investment in bonds.
i. Derivatives: futures and interest rate swaps.
Carlos Calderon Gonzalez
ii. Exchange traded funds (ETF): easily traded and high liquidity
4. Modeling expected return
a. Income yield: Coupon/Price
b. Rolldown return: Assumes yield curve is unchanged. (end horizon period projected price – beginning
price) / beginning rprice
c. Expected price change: bsed on ivnestors expected change in ield and spread. –
MD*chg(Y)+1/2C*chng(Y^2)
d. Credit losses: Probability of default times epceted loss severity
e. Expected gains or losses vs. investors currency
5. Leveraging returns
a. Leverage: increase return, attractive at lower interest rates.
i. If Rinv > Rborrow, leverage enhance portfolio return, but increase exposure to interest rate ris.
ii. Borrowing normally done in ST interest rate, and those cost can increase faster
iii. Leveraged portfolio Dassets> Dliabilities
iv. Leverage portfolio return = Rinv = (Vb/Ve) * (Rinv-Rborrow)
b. Multiple ways to achieve leverage
i. Repurchase agreements (Repo)
1. Sell a security for cash, and agree to buy it back in a future date.
2. Loan term often overnight, renegotiated next day at new interest rate.
3. General collateral: not specified actual securities
4. Haircut amount provides additional security to the money lender. Haircut is larger for
riskier and less liquid securities
5. Can be bilateral or tri-party (intermediate, holds collateral and record exchange of
ownership)
6. Cash driven or security driven (money lender wants temporary possession of specific
collateral)
ii. Future contracts
1. Small initials margin deposit, but full upside/downside of buying
2. Contract price* multiplier = full price
3. Leverage = (notional value of contract – margin amount) / Margin amount
iii. Swap agreements
1. Receive-fixed swap increase portfolio exposure to bond market with no explicit
investment.
iv. Structured finance instruments: inverse floater.
v. Securities lending:
1. Supports short-selling, must borrow the security form someone else. Receive cash and
invest it.
2. Rebate rate: collateral earnings rate – security lending rate
3. Usually open ended, no specific maturity and continue until one counterparty requires
settlement: additional risk.
4. Earnings depend on how badly securities borrower needs that collateral.
c. Risks created by leverage
i. Interest rate increases, value of portfolio and collateral declines, induce money lender for
repayment, force liquidate, fire sale, distressed conditions, vicious cycle.
6. Managing Taxable and Tax-exempt Portfolios
Carlos Calderon Gonzalez
a. Tax issues examples
i. Income, capital gains = when realized but different rates. Zero-coupon bonds, imputed income
may be taxed each year
ii. Capital gains tax (only at sale) < Interest Income tax
iii. Capital gains tax (LT) < (ST)
iv. Capital losses only allow to offset capital gains r future realized losses.
v. Tax-sheltered or tax-advantaged accounts.
b. Strategies with taxable accounts
i. Realize capital losses to offset gains
ii. Extend holding periods to realize LT capital gains
iii. Extend holding period to defer taxes
iv. Consider differentials between income vs. gain tax rates
c. Taxes in mutual funds
i. Income on the underlying, taxable.
ii. Options on G/L
1. G/L passed through and taxed when realized
2. G/L realized within the fund, affect when investor sells fund shares

Liability-Driven and Index-Based Strategies

1. Definitions
a. Asset-liability management (ALM): strategies that consider assets in relation to liabilities
b. Liability-driven investment (LDI): liability as a given, and manage assets to meet liabilities
c. Asset-driven-investing (ADI): assets as a given, and manages liabilities in relation to assets
2. Types of liability-driven investing (LDI)

Type I Known future amount and payout dates Option-free fixed rate bond Simple duration
Type II Known future amount, uncertain payout dates Callable/Puttable bond
Type III Uncertain future amount, known payout dates Floating rate / TIPS Effective duration
Type IV Uncertain future amount and payout dates Property and Casualty
3. Immunizing a single liability
a. Immunization: minimize variability of rate of return, FV confidently predicted.
b. Cash flow matching: simples but least flexible
c. Duration matching
i. Macaulay duration: balance price risk = reinvestment risk. Assumes parallel movement
ii. Modified duration: more accurate, more appropriate for some techniques.
iii. Money duration: = MD*V*0.0001
d. Portfolio statistics should be use
i. Flat yield curve: no difference
ii. Upward-sloping yield curve: portfolio Dur and IRR > weighted average of bonds.
e. Goal: earn the initial portfolio IRR, not the average YTM of the bonds.
f. Structural risk: dispersion (related with convexity)
i. Conv = (Dmac^2+Dmac+Disp) / (1+IRRperiodic)
ii. Conv/Disp: Risk exposure of the immunization strategy to structural risk from shifts and twists in
the yield curve
iii. Structural Risk: IRR doesn’t match yield of the replicating zero or insufficient to fund liability
g. Effects of yield curve changes | Duration matching (Barbell portfolio) have Structural risk
Carlos Calderon Gonzalez
i. Parallel move
1. outperform, positive convexity effect (be parallel is sufficient, but not necessary)
2. Zero replication: risks are low, but not risk free
3. Does not mean buy and hold, to maintain immunization: rebalance
ii. Steepening twist: Barbell underperform. PVA<PVL
iii. Flattening twist: Barbell outperform. PVA>PVL
iv. Positive butterfly twist: Barbell underperform PVA<PVL
v. Negative butterfly twist: Barbell outperform. PVA>PVL
h. Rules for immunizing
i. PVA >= PVL
ii. DA=DL
iii. Minimize portfolio convexity
iv. Regularly rebalance the portfolio
4. Immunizing multiple liabilities
a. Cash flow matching
i. Safest approach.
ii. Accounting defeasance: assets legally set aside, dedicated to meet liabilities, remove from BS
iii. Match stream of liabilities using coupon-bearing bonds in a recursive fashion.
iv. Cash-in-advance constraint, expose to reinvestment risk.
b. Duration matching
i. More flexible and practical
ii. Sufficient assets to fund liability,
iii. PVA>=PVL, so match BPVA=BPVL
iv. Asset dispersion/convexity > liabilities (not too much, minimize structural risk exposure)
v. Regularly rebalance
c. Derivatives overlay
i. Futures. Seller must deliver CTD bond (Cheapest to deliver) | buyer mst pay initial contract price
multiplied by conversion factor.
ii. CTD determines duration and BPV.
iii. Futures BVP = BPV(CTD)/CF(CFD)
iv. Number of contracts = N = (BVP(Liabilities)-BVP(portfolio)) / BPV(futures)
d. Contingent immunization
i. Hybrid active/passive strategy, requires significant surplus
ii. Examples
1. Invest all in stocks
2. Invest only the surplus and balance in a immunized portfolio.
3. Active bond management techniques: Rates will increase, under hedge | rates will
decrease, over hedge
iii. Vulnerable to liquidity risk
5. LDI strategies applied to a pension fund
a. Pension funds: Type IV liabilities.
b. Types
i. Futures
1. creates operational and practical risks, margin must be posted daily
2. Successful hedge: G/L offset to changes in liability, but as an unrealized value.
Carlos Calderon Gonzalez
3. 100% hedge rare
ii. Interest rate swaps
1. Avoid cash flow issues of futures.
2. Received fixed swap = buying more bond assets and increase portfolio duration.
3. Pay fixed swap = reduce duration
4. Many swaps now require periodic marking to market and posting margin to reduce
counterparty and credit risk, some practical CF complications.
iii. Swaption
1. Initial premium for the right to enter a swap.
2. Receive swaption: need to increase BPV, right to initiate a receive-fixed at a prespecified
swap fixed rate (SFR), swaption strike rate
a. If SFR declines, the right has positive value, increases BPV of assets
b. If SFR increase, the right has no value, worthless
iv. Swaption Collar
1. Buying one swaption and selling another.
2. Buy receive swaption = benefit if SFR declines
3. Sell payer swaption: reduce initial premium, limit future benefits
6. Choosing an optimal strategy
a. Depends on managers view of interest rates.
b. Choices
i. Receive-fixed swap vs. pay LIBOR (if r<r*)
ii. Receiver swaption(if r>r(ps) )
iii. Zero-cost collar: buying receive swaption, selling payer swaption (if r*<r<r(ps)
7. Liability-driven investing risks
a. Hedge amounts = approx. based on assumed durations and ignore convexity
b. Duration = parallel shifts
c. Twists of yield curve = structural risk. Asset convexity > liability convexity, and imitate dispersion
d. Model risk can be significant
e. Measurement error
f. Futures BPV calculations based on a CTD bond. Adjust for accrued interest discounted at St rates.
g. Portfolio yield <> liability discount rate, different risk levels = spread risk
i. Liability discount rate = corporate debt rates | Portfolio yield = govt bond rates
ii. Treasury rates: subtle risk, highly liquid, higher reported volatility, higher rate of change.
iii. Swaps creates spread risks as reflects LIBOR market
h. OTC derivatives have counterparty risk. Requiring collateral reduces counterparty risk, but creates cash
flow risk.
i. Asset liquidity risk
8. Bond indexes
a. Low cost diversification. Alternative to active fixed-income management. Goal to minimize tracking error.
b. Approaches
i. Pure index, full replication = holding securities
ii. Enhanced indexing: matches primary risk exposures
c. Indexing bonds more difficult than equity
i. Much larger, more issues, characteristics vary.
ii. One issuer = multiples issues. Differ substantially in liquidity
Carlos Calderon Gonzalez
iii. Most bond trading is done OTC. Capital requirements, high capital cost, reduce willingness to
hold inventories, increase bid-ask spread, low liquidity
iv. Many transactions not publically reported, difficult to obtain data, so evaluated pricing. If
features are more unusual, more difficult to find appropriate traded bond to use
d. Matching primary risk factors

Modified duration Parallel shifts %chng(value)=-MD*chng(r)

KRD Nonparallel shifts %chng(value) =-KRD5*chng(r5)
Spread duration Bond sector and quality %chng(rel value) = -Ds*chng(s)
Effective duration and convexity Sector/couon/maurtity cellw eights
Issuer weights Specific event risk
e. Method of minimizing yield curve: matching PV distribution of CF
9. Alternative methods of obtaining passive bond market exposure
a. Stratified sampling (cell matching)
i. Enhanced indexing, determines most significant characteristics.
ii. Can include environmental, social and corporate governance (ESG) or socially resposnibel
restriction.
b. Relevant techniques, reduce expense of pure indexing
i. Reducing fund expenses
ii. Overweighting undervalued, underweighting overvalued, favor areas of spread narrowing
iii. Overweighting callable bonds, when interest rate vol are expected to be low
10. Methods Passive Bond Market exposure
a. Mutual funds: small investors, broad market exposure, economies of scale
b. Open-ended fund: redeemed or purchased at NAV once per day, charge fees, do not typically mature.
c. Exchanged-trade funds: shares trade continuously, typical investor cannot purchase or redeem shares
directly, authorized participant can redeem with pro rata distribution. Redemption and purchase in kind
creates arbitrage mechanism between one-market price of fund shares and NAV, less effective due to
illiquidity
d. Synthetic strategies
i. Total return Swaps (TRS): receive index total return, pay LIBOR + spread.
1. fully collateralize the swap by holding sufficient cash equivalents to have purchased the
underlying index
2. not fully collateralized: leveraged investment
3. counterparty is normally a dealer with greater economies of scale
4. Disadvantages
a. Counterparty risk: Do not won the underlying securities
b. Rollover risk: Normally ST in nature
c. Costs in the swap terms: transaction and liquidity issues make direct investment
impractical.
d. Structural and regulatory changes
ii. Exchange-traded derivatives
1. Structural and regulatory changes
2. Starting 2006: US allowed futures contracts based on bond indexes, not been popular
11. Bond Benchmark selection
a. Defining clients objectives and constraints = SAA = Tactical discretion
b. Selecting suitable bond indexes = complicated
Carlos Calderon Gonzalez
i. Duration will decline as age
ii. New bond issuance = characteristics will change
iii. Value-weighted indexed = greatest weight to largest issuers
c. Custom index: desired duration an sector exposure
d. Smart beta rules = identifying relatively simple, definable rules.
e. Credit barbell: LT treasuries (desirable duration exposure) + ST corporate, additional spread return, less
vulnerable to relative price underperformance when spreads widen
12. The laddered bond approach
a. Advantages
i. Natural liquidity
ii. Broadest diversification of CF across time an yield curve
iii. Diversification between price and reinvestment risk
iv. More convexity than bullet
v. Duration contributions will differ, respond differently to nonparallel twist.
vi. Alternative: target date bond ETFs, cost advantage and more liquidity
b. Disadvantages
i. Passive index or active bond fund may be better = greater diversification and liquidity

STUDY SESSION 11

Yield Curve Strategies

1. Strategies for an unchanged upward sloping yield curve

a. Buy and hold
i. Buy duration risk to enhance portfolio yield.
b. Riding the yield curve
i. Long maturities, plan to sell them and extend maturity, this around a relatively steep segment of
the yield curve
c. Selling convexity
i. Reducing portfolio convexity to increase yields.
ii. Advantageous when rates are volatile, bonds with greater convexity will have lower yields
iii. Ways
1. Sell calls and sell puts on bonds
2. Callable bonds: if rates unchanged bond with higher yield. If increase, loss. If decrease,
call
3. MBS: if rates decrease, prepay increases. At higher rates, no incentive to prepay,
decreasing cash flow to reinvest at higher rates, reduces return. If rates unchanged,
good.
d. Carry trades
i. Buy security at a higher yield, financing with a lower interest rate, do well in stable markets, very
risky in highly volatile markets.
1. Curve carry trade: borrow ST and invest LT (upward sloping and stable YC)
2. Dual currency carry trade: borrow lower rate and invest higher rate (if currency is
stable), if currency risk is hedges is not carry trade.
3. Crowding risk: mass effort to unwind a trade.
2. Strategies for changes in the level, slope or shape of the yield curve
Carlos Calderon Gonzalez
a. Adjusting portfolio duration
i. If E(rate increase) = decrease duration (parallel shift)
ii. KRD = nonparallel shifts. Constraint: keeping total duration unchanged.
b. Increasing convexity
i. Increase convexity when interest rates are epected to be volatile.
ii. Greater convexity: increase more when rates fall, decrease less when rates rise. But offer lower
yields.
iii. Increase dispersion of maturities.
c. Bullet, laddered and barbell strategies

Duration Distribution Convexity Outperform

Laddered Same Equally across Medium
Bullet Same Single point Lowest Curve steepens
Barbell Same d Longer and shorter Highest Curve flattens
3. Use of derivatives
a. Increase portfolio duration
i. long futures
1. Sensitive to interest rate changes
2. No cash outlay at inception
ii. leverage
1. Borrow ST rate and adding proportionally to all positions preserving weights
iii. Swaps
1. Taking pay-floating, receive fixed swap = borrow ST floating and invest in Fixed-rate
bond
2. Long swaps expose to curve risk
b. Increase portfolio convexity
i. Buy bond call option
ii. Selling portfolio bonds to purchase options on bonds, keeping duration constant
iii. Uncertainty of direction of future rates = demand for convexity is high, high option price, so
some is already reflected in price.
4. KRD
a. Measure sensitivity to bond values to yield changes in specific maturities.
5. Duration-neutral govt bond portfolio
a. Curvature of YC increases = barbell will perform best
b. Curvature decreases = bullet will outperform
c. Butterfly portfolio uses leverage to capture value of curvature changes
i. Short the body and long the wings (super barbell)
1. Shorting intermediate term bonds and investing in barbell portfolio
2. Outperform when curvature rises (higher intermediate-rates)
ii. Long the body and short the wings (super bullet)
1. Shorting barbell bond and investing in intermediate-term bonds.
2. Outperform when curvature decreases (lower intermediate rates)

Credit strategies

1. Investment grade vs. high yield

a. Investment grade: >= BBB-, Baa3; lower credit and default risk, lower yield and yield spread
Carlos Calderon Gonzalez
b. High yield: below investment-grade
c. Rating agencies assess five Cs
i. Capacity
ii. Collateral
iii. Covenants
iv. Character
v. Capital
2. Risk considerations
a. Risks
i. Credit risk: failure to pay
1. Default risk (Prob will not make payment) * loss severity (percent of par not paid)
ii. Spread risk: decline price relative to credit risk free bonds due to spread widening
iii. Credit migration risk: risk decline in credit quality and bond rating.
iv. Spread duration: price change if only spread change, decompose two sources.
v. Liquidity risk: ability to buy/sell quickly at near fair value
1. Bid-ask spread wider for Y, size is smaller
2. Regulatory and risk management issues are greater for HY
3. HY more costly to trade, turnover is lower
vi. IG: quoted as spread from benchmark, HY as a price.
b. Floating rate securities: little duration (linked to reset), but high spread duration (linked to maturity)
i. Price is insensitive to rate change because the future coupons adjust upward, bust not to spread.
c. Generally negative correlation between rf and spread
i. Stronger economic conditions = increasing rf, decrease risk of default
ii. Canceling effect most pronounced for HY, their price change is driven more by spread change.
d. Effective and empirical duration differs
i. iG: empirical duration < effective duration, difference increased moving down with rating
ii. HY: differences increased dramatically, empirical duration for B, empirical duration negative to C.
e. IG exposed to interest rate risk, HY exposed to credit and spread risk
3. Credit spread measures
a. Benchmark spread: YTMbond – similar duration rf bond
b. G-spread: interpolated spread form govt. not useful for bonds with embedded options
c. I-spread: swap fixed rates as benchmark
i. Advantage: smoother yield curve
ii. Disadvantage: SFR no rf but good in normal economic conditions
d. Z-spread: single spread that if added, you get current market value. Not consider embedded option
features.
e. OAS: reflect impact of options on expected return; require assumption of interest rate volatility. Single
spread If added to the tree, discount bond future cash flow to current market value. Measure of
incremental return for credit risk, but may be misleading (average result).
f. Weighted average OAS: best measure for credit exposure for portfolio of bonds with and without
embedded options
g. Estimated excess of return (EXR) = (S*t)-(ch(s)*SD)-(t*p*L)
i. S= spread, t= period, SD: spread duration, p=prob of default, L=severity of loss
4. Bottom-up vs. top-down approaches

Bottom-up Top-down
Carlos Calderon Gonzalez
Easier information advantage Harder information advantage
Focus on least efficient sectors Problem: same factors examined by many others
Work best comparing bonds with homogenous credit risk
exposure
Problem: macro factors can overwhelm Advantage: focus directly to macro factors
Combine: overwight undervalue/ underweight overvalue, Macro factors, then individual security analysis
adjust for macro factor exposure
5. Bottom-up in detail
a. Identify universe, divide by sectors, match benchmark wights, over/underweight securities.
b. Look for misevaluation, weight compensation vs. credit risks.
c. Gather information: default rates, loss rates, past spread relationships
d. Estimated excess of return (EXR) = (s*t)-(ch(s)*SD)-(t*p*L)
i. S= spread, t= period, SD: spread duration, p=prob of default, L=severity of loss
e. Select highest XR. Exceptions: need diversify, emphasize high liquidity
f. Spread curves
i. Liquidity
ii. Date of issuance
iii. Pending new supply
iv. Seniority in bankruptcy
v. Size of issue and total issuance outstanding by issuer
g. Practical considerations
i. Identifying optimal exposures and best relative value holdings
ii. Exposure to credit risk: spread duration and market value
1. IG: SD and duration contribution
2. HY: high default risk, market value allocation is more relevant
iii. Best relative value:
1. Move down his relative value list
2. Invest in suitable index fund
3. Hold cash until available
6. Top-down in detail
a. Focus on macro factors: strength growth and corporate profits
b. Uses
i. Identify when to focus in HY vs. IG
ii. Identify sectors
c. Focus on historical patterns: credit cycle (variations growth and default rates, negatively correlated),
credit spread (default rates and spreads highly correlated)
d. How portfolio average quality is calculated:
i. Numeric sequence, average of rating. This can understate exposure to credit risk, because
default rates and losses increase rapidly with rating declines
ii. Non-arithmetic portfolio averages: exposure to credit risk increase at faster than linear rate, as
bond rating declines.
e. Duration time spread (DTS): Spread duration (how impact value and Spread (greater exposure to credit
risky asset)
f. Historical spreads between credit risky sectors to assess relative attractiveness
7. Adjusting the credit portfolios interest rate risk
a. Top-down: more likely to actively manage interest rate risk
Carlos Calderon Gonzalez
b. Bottom-up: match interest rate exposure, focus on security selection
c. Difficult to manage interest rate and credit risk without derivatives
i. View: spreads narrow, rates increase. Buying corporates for increase spread exposure, selling
bond futures to lower duration.
ii. Adjusting exposure to options. Difficult: with callable and putable bonds. Straightforward:
options
iii. Currency forwards and bond futures adjust currency and duration exposures
d. ESG considerations (environmental social and governance)
8. Managing liquidity risk
a. In a crisis
i. Daily trading volume down
ii. Credit spread sensitive to flow of funds.
iii. Larger impact on HY as smaller and less liquid
iv. Difference in bid-ask less reliable.
v. Capital and risk consideration reduced the size of dealer’s inventory.
vi. Broader distribution: favorable trend to liquidly. Greater number and dispersion of participants:
resilient and more liquid
b. Managing liquidity risk
i. Hold cash
ii. Hold liquid securities
iii. Use liquid derivatives instruments: regularly traded CDS
iv. Use IG or HY ETFs as temporary investment
9. Managing tail risk
a. Tail risk: more large declines, difficult to model or anticipate
b. Quantify potential losses
i. Scenario analysis
ii. Historical scenarios
iii. Hypothetical scenarios
c. Severe adverse market conditions:
i. Correlation upward
ii. Diversification benefits declines
iii. Downside risk greater
iv. Liquidity declines or disappear
d. Is difficult
i. Quantify the risk and hold adequate top quality securities to retain liquidity
ii. Identify tail risks and hold securities likely to benefit when risk occurs
iii. Tail risk hedges: CDS, credit spread options. Problem: cost incurred at purchase, more the
marketplace believes the risk is likely, most expensive the protection
10. International credit risks
a. International investing
i. greater relative value opportunities.
ii. New issuance may exceed desired demand
iii. Subtle quality differences may exist
b. EM bond sector similar in size to US HY sector. But differences, EM sector:
i. Commodity and banking related business.
Carlos Calderon Gonzalez
ii. Direct government ownership in companies is high: explicit/implicit expectation of support, legal
right for foreign investors less clear
iii. Rating for non-govt understates true quality as cap is govt.
c. Global bond portfolios
i. Liquidity greater concern
ii. Currency risk
iii. Legal risk
11. Structure finance instruments
a. Offer a combination of
i. Higher yield and expected return
ii. Tailored risk exposure, multiple tranches
iii. Exposure to specific market sectors
iv. Diversification benefit
b. Multiple types
i. MBS: pools of mortgage backed loans. Compared to corporate bonds
1. Govt agency backed MBS: similar yields and spread, greater trading volume, liquidity
2. Tailored exposure to specific segments of real estate market.
3. Adjusting portfolio exposure to interest rate volatility. Prepay option = embedded short
call option. But MBS market is larger, more liquid, less default risk.
a. Increasing rates or higher rate vol, prepay option becomes more valuable.
ii. Asset-backed securities (ABSs): backed by non-mortgage debt.
1. Different source: return and diversification
iii. Collateralized debt obligation (CDOs): various form of debt obligation, structured in tranches.
1. Credit quality descends and expected return increases as you move down to trancehs.
2. Little diversification but:
a. opportunities to identify relative value
b. express a view on correlation within underlying collateral
i. +1 buy lower tranches, as same prob of default
ii. -1 highest tranches, as some collateral must be paid.
c. Leverage exposure to credit risk
iv. Covered bonds: issued by a financial entity, form of collateralized debt. General obligation of
issuer, lower risk investment than general bonds.