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Advanced Bond Portfolio Management ffirst.frm Page iii Monday, November 21, 2005 1:15 PM Advanced Bond Portfolio Management Best Practices in Modeling and Strategies FRANK J. FABOZZI LIONEL MARTELLINI PHILIPPE PRIAULET EDITORS John Wiley & Sons, Inc. ffirst.frm Page iv Monday, November 21, 2005 1:15 PM Copyright © 2006 by John Wiley & Sons, Inc. All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or oth- erwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rose- wood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Per- missions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies con- tained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. ISBN-13 978-0-471-67890-8 ISBN-10 0-471-67890-2 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 ftoc.frm Page v Monday, November 21, 2005 1:16 PM Contents Preface ix About the Editors xv Contributing Authors xvii PART ONE Background 1 CHAPTER 1 Overview of Fixed Income Portfolio Management 3 Frank J. Jones CHAPTER 2 Liquidity, Trading, and Trading Costs 21 Leland E. Crabbe and Frank J. Fabozzi CHAPTER 3 Portfolio Strategies for Outperforming a Benchmark 43 Bülent Baygün and Robert Tzucker PART TWO Benchmark Selection and Risk Budgeting 63 CHAPTER 4 The Active Decisions in the Selection of Passive Management and Performance Bogeys 65 Chris P. Dialynas and Alfred Murata v ftoc.frm Page vi Monday, November 21, 2005 1:16 PM vi Contents CHAPTER 5 Liability-Based Benchmarks 97 Lev Dynkin, Jay Hyman, and Bruce D. Phelps CHAPTER 6 Risk Budgeting for Fixed Income Portfolios 111 Frederick E. Dopfel PART THREE Fixed Income Modeling CHAPTER 7 Understanding the Building Blocks for OAS Models 131 Philip O. Obazee CHAPTER 8 Fixed Income Risk Modeling 163 Ludovic Breger and Oren Cheyette CHAPTER 9 Multifactor Risk Models and Their Applications 195 Lev Dynkin and Jay Hyman PART FOUR Interest Rate Risk Management 247 CHAPTER 10 Measuring Plausibility of Hypothetical Interest Rate Shocks 249 Bennett W. Golub and Leo M. Tilman CHAPTER 11 Hedging Interest Rate Risk with Term Structure Factor Models 267 Lionel Martellini, Philippe Priaulet, Frank J. Fabozzi, and Michael Luo CHAPTER 12 Scenario Simulation Model for Fixed Income Portfolio Risk Management 291 Farshid Jamshidian and Yu Zhu ftoc.frm Page vii Monday, November 21, 2005 1:16 PM Contents vii PART FIVE Credit Analysis and Credit Risk Management 311 CHAPTER 13 Valuing Corporate Credit: Quantitative Approaches versus Fundamental Analysis 313 Sivan Mahadevan, Young-Sup Lee, Viktor Hjort, David Schwartz, and Stephen Dulake CHAPTER 14 An Introduction to Credit Risk Models 355 Donald R. van Deventer CHAPTER 15 Credit Derivatives and Hedging Credit Risk 373 Donald R. van Deventer CHAPTER 16 Implications of Merton Models for Corporate Bond Investors 389 Wesley Phoa CHAPTER 17 Capturing the Credit Alpha 407 David Soronow PART SIX International Bond Investing 419 CHAPTER 18 Global Bond Investing for the 21st Century 421 Lee R. Thomas CHAPTER 19 Managing a Multicurrency Bond Portfolio 445 Srichander Ramaswamy and Robert Scott ftoc.frm Page viii Monday, November 21, 2005 1:16 PM viii Contents CHAPTER 20 A Disciplined Approach to Emerging Markets Debt Investing 479 Maria Mednikov Loucks, John A. Penicook, Jr., and Uwe Schillhorn INDEX 533 fpref.frm Page ix Monday, November 21, 2005 1:18 PM Preface onds, also referred to as fixed income instruments or debt instruments, Bhave always been and will likely remain particularly predominant in institutional investors’ allocation because they are typically the asset class most correlated with liability structures. However, they have evolved from straight bonds characterized by simple cash flow structures to securities with increasingly complex cash flow structures that attract a wider range of investors. In order to effectively employ portfolio strategies that can control interest rate risk and enhance returns, investors and their managers must understand the forces that drive bond markets, and the valuation and risk management practices of these complex securities. In the face of a rapidly increasing complexity of instruments and strategies, this book aims at presenting state-of-the-art of techniques related to portfolio strategies and risk management in bond markets. (Note that throughout the book, we use the terms “fixed income securi- ties” and “bonds” somewhat interchangeably.) Over the past several years, based on the collective work of numerous experts involved in both practitioner and academic research, dramatic changes have occurred in investment best practices and much progress has been made in our understanding of the key ingredients of a modern, structured, portfolio management process. In this book, these ingredients that con- tinue to shape the future of the bond portfolio management industry will be reviewed, with a detailed account of new techniques involved in all phases of the bond portfolio management process. This includes cov- erage of the design of a benchmark, the portfolio construction process, and the analysis of portfolio risk and performance. The book is composed of six parts. Part One provides general background information on fixed income markets and bond portfolios strategies. Chapter 1 by Frank Jones pro- vides a general classification of bond portfolio strategies, emphasizing the fact that bond portfolio strategies, just like equity portfolio strate- gies, can be cast within a simple asset management setup, or alternatively and arguably more fittingly, cast within a more general asset-liability management context. The chapter not only covers standard active and ix fpref.frm Page x Monday, November 21, 2005 1:18 PM x Preface passive bond portfolio strategies; it also provides the reader with an introduction to some of the new frontiers in institutional portfolio man- agement, including an overview of the core-satellite approach as well as an introduction to portable alpha strategies. In Chapter 2, Leland Crabbe and Frank Fabozzi offer a thorough and detailed analysis of liquidity and trading costs in bond markets. While active trading is meant to generate outperformance, it can also result in efficiency loss in the presence of market frictions. Because it is quite often that the presence of such frictions may transform a theoretically sound active bond portfolio decision into a costly and inefficient dynamic trad- ing strategy, one may actually argue that the question of implementation of bond portfolio management decisions is of an importance equal to that of the derivation of such optimal decisions. The elements they present in Chapter 2 are useful ingredients in a bond portfolio optimiza- tion process that accounts for the presence of trading costs. A first view on the fundamental question of the design of fixed income benchmarks in the context of active bond portfolio strategies is provided by Bülent Baygün and Robert Tzucker in Chapter 3. They begin by explaining how different methods can be used in the process of benchmark construction, with a key distinction between rule-based methods meant to ensure that the benchmark truthfully represents a given sector of the market, and optimization methods to ensure that the benchmark is an efficient portfolio. They then explore various aspects of the active portfolio management process, which allows managers to transform their view on various factors affecting bond returns into meaningful and coherent portfolio decisions. Part Two is entirely devoted to the first, and perhaps most important, phase in the bond portfolio management process: the design of a strategy benchmark. In Chapter 4 Chris Dialynas and Alfred Murata presents a useful reminder of the fact that existing commercial indices contain implicit allocation biases; they then explore the market conditions and factors that result in outperformance of one versus another bond index. Overall, the chapter conveys the useful message that selecting a bench- mark accounts for most of the eventual portfolio performance. Lev Dynkin, Jay Herman, and Bruce Phelps revisit the question of bond benchmarks from a liability-based standpoint in Chapter 5. Exist- ing commercial indices are not originally designed to serve as proper benchmarks for institutional investors; instead they are meant to repre- sent specific given sectors of the bond markets.
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