Partial Durations: The Case of Fixed and Floating Rate Bonds

Floating rate bonds are coupon-paying instruments generally indexed to interest parameters. At the trading date, the payment dates and indexation rules are known, while the value of future coupons is uncertain. In this perspective, floating rate bonds are generally seen as a portfolio of zero coupon bonds. Therefore, at each coupon payment date, the bond should be quoted at face value and its duration should match the maturity of the replicating zero coupon bond. However, the empirical evidence based on historical prices of real floating rate bonds shows that such an instrument is not systematically quoted at parity and its market risk profile could differ from that of the replicating zero coupon bond. The aim of this work is to study the duration of a floating rate bond using a partial modified duration approach after decomposing the floating rate bond into its main building blocks. The final goal is to capture the effective risk factors of these instruments in real financial markets in order to define synthetic risk measures that should be able to reflect the instrument\u2019s effective risk profile

Practical Finance Strategies in Immunization

My first goal is to present the basic immunization problem (BIP) as it is understood in finance. BIP relies on a construction of such a bond portfolio (BP), meaning a selection of individual bonds, that the single liability to pay L dollars q years from now will be discharged by means of BP (a patient will return to health at time q), no matter what random shift a(t) (a particular disease) will occur in the future. What kind of a function is a shift of interest rates is critically important because both present and future values of BP depend solely on underlying interest rates. Having identified shifts (diseases) against which a BP is immunized, the natural question arises how to find among such immunized (immune) portfolios the best ones. In the context of finance, it means bond portfolios with maximal unanticipated rate of return. My second goal is to trigger interest among medical scientists by suggesting that certain finance notions, such as duration and convexity of a bond portfolio, might give extra insight to medical researchers working in the immunization area both into BIP and into similar problems in medicine. A considerable attention is also paid to certain mathematical notions (base of a linear space, a Hilbert space, triangular functions) because of their successful applications to problem-solving occurring in bond portfolio immunization

Market Risk Measurement: Key Rate Duration as an asset allocation instrument

Currently, the financial institutions are exposed to different types of risks, including the market, credit and operational risks; therefore, there has increased the need for new financial and analytical instruments for the risk management. Among the traditional ones we have the duration, which measures the bond price sensitivity to changes of interest rates. Nevertheless, it has two disadvantages: it assumes parallel changes in the yield curve and it is inaccurate if we consider large percentage changes. In this sense, a tool that allows correcting these disadvantages is The Key Rate Durations. The present work tries to provide an additional tool to the investment analysis, so the economic agents can adopt better decisions

Empirical essays on portfolio immunization

This thesis is dedicated to interest rate risk immunization. Several widely known immunization strategies, like the naïve and duration-matching bullet and barbell, will be implemented and tested empirically. Furthermore, the M-Absolute, M-Squared and M-Vector strategies will also be implemented and tested empirically in order to evaluate if their additional complexity adds any value to the immunization process, while bearing in mind that these strategies immunize portfolios against both non-parallel and parallel shocks in the term structure of interest rates. A common methodology will be applied to different bond datasets in order to infer what is the best and most consensual immunization strategy.Esta tese de doutoramento é dedicada à imunização de risco de taxa de juro e explora a implementação empírica de múltiplas estratégias de imunização de carteiras. Serão implementadas estratégias comuns, como a estratégia de maturidade naïve e as estratégias bullet e barbell que assentam na premissa de equivalência entre a duração das carteiras de ativos e da responsabilidade futura a imunizar. As estratégias M-Absolute, M-Squared e M-Vector serão também implementadas, de modo a aferir se a sua complexidade adicional se justi…ca, dada a necessidade de acomodar a possibilidade de movimentos não paralelos da estrutura por prazos de taxas de juro durante o processo de imunização de carteiras. Para aferir qual a estratégia de imunização de carteiras mais consensual foi desenvolvida uma metodologia comum a aplicar aos três conjuntos de obrigações considerados nesta dissertação

Immunization, stochastic process risk, and optimal objective functions: Reexamination of the duration vector model with Monte Carlo sampling.

In Part One of this dissertation, the Chambers, Carleton, and McEnally (CCM) model is reexamined by two separate empirical designs. In the first, the CCM quarterly data test is replicated with a larger sample and with the Fong and Vasicek (1984) M\sp2 minimization objective function. In the second design, Monte Carlo sampling is employed to test over five year holding periods. Five separate Monte Carlo samples are evaluated. While the quarterly data test suggests that the duration vector model does not significantly outperform the optimally selected single factor duration model, the Monte Carlo tests are consistent in their support of a two factor duration vector with D1 and D2. The tests also show that duration vector factors D3 and beyond are not warranted. This is not consistent with the CCM (1988) claim that five to seven factors are optimal.The concept of immunization as a vehicle for managing interest rate risk in bond portfolios has developed heuristically over time. It is a risk hedging procedure whose appeal is due to its simplicity and ease of application. Simple single factor duration models, however, have fallen short of expectations in empirical tests. Consequently, more complex multiple factor and stochastic models have been advanced as superior immunization alternatives. Most of these models lack appeal either because of their complexity or because they, too, have fallen short in empirical tests. A notable exception is the multiple factor duration vector model by Chambers, Carleton, and McEnally (1988). Reexamination of that study is the primary focus of this dissertation. In addition, the relative efficacy of alternative objective functions for selecting single factor duration portfolios is also examined.In Part Two, the minimize M\sp2 objective function is examined against five alternative strategies by the Monte Carlo sampling design. Again, five independent samples are evaluated. The results clearly support this objective function as optimal in single factor immunization

Flight-to-Quality phenomenon as a source of financial instability

Doutoramento em EconomiaA general theoretical framework is proposed to analyse Flight-to-Quality events, defined as a mass investment migration from risky to safe assets. The model consists of only two asset classes, risky and safe. The framework is applied to Flights-to-Quality from emerging market public debt to U.S. treasuries, in the period 1998-2010. An alarm signal system is designed to warn of upcoming Flights-to-Quality and their terminations, and is applied: (i) to delimiting hypothetical Flights-to-Quality on an ex-ante basis, which are compared with historically observed episodes, to test the quality of the alarm signals; (ii) to elaborate dynamic interest rate risk hedge strategies, characterized by higher returns and lower volatility in comparison with statically hedged investments. The proposed framework potentially allows for improving the timeliness of financial policies, which can be triggered by the alarm signals. It can also be a useful tool for defining adequate policies to be implemented acting either on an insufficient supply of the safe assets or on a decreasing demand for the risky investments, thus contributing to a more stable economic environment.Propõe-se uma abordagem teórica para análise de eventos Flight-to-Quality, definidos como a migração em massa de investimentos em, activos com risco para investimentos em activos sem risco. O modelo considera apenas dois tipos de activos, com e sem risco. A abordagem é aplicada a eventos Flight-to-Quality da dívida pública de mercados emergentes para dívida pública norte-americana, no período 1998-2010. É desenhado um sistema de sinais de alerta para emitir sinais de aviso relativos ao início e ao término dos eventos Flight-to-Quality, o qual é utilizado para: (i) a identificação ex-ante (hipotética) dos eventos, os quais são comparados com os eventos históricos observados, para testar a qualidade dos sinais gerados; (ii) para elaborar estratégias dinâmicas de cobertura de risco da taxa de juro, que asseguram rendimentos mais elevados e menor volatilidade que estratégias de cobertura de risco estáticas. A abordagem proposta permite melhorar o tempo de resposta das políticas financeiras, as quais podem ser despoletadas pelos sinais de alarme. E pode também ser um instrumento útil para a definição de políticas, seja para correcção de uma oferta insuficiente de activos sem risco ou de uma procura insuficiente pelos activos com risco, contribuindo assim para um ambiente económico mais estável