Active management in practice, Financial Management

Constant Duration

To improve a buy and hold strategy a constant average duration is imposed for the managed portfolio during the full interest rate cycle. This is done because interest rates follow a mean reversion process. In case interest rates move above their average value, they tend to decline later. In contrast, if the interest rates move below average, then they will rise later.

Initially, consider the level of interest rates fluctuation is at middle range (i0 ) and the average level of index duration is D0.  If the interest rates increase from this level, the duration of index will decline. At the same time, if the portfolio manager matches his portfolio duration to index duration, it will result in replication of index performance. When interest rates move to an upper trigger limit iU, subsequently the manager will bring his portfolio duration to the average level of the index duration D0. By maintaining a constant duration D0 for the bond portfolio till the interest rates move back to their average level i0, the portfolio manager will take an active positive exposure that will be rewarded, given the term structure declines later on. In the case of decline in interest rates from level i0 and with a lower trigger limit iL, an opposite argument can be applied.

The success of above strategy will depend on the assumption that the process involved behind the movement in interest rates is mean reverting. This implies that the interest rates should fluctuate in a reasonably well defined and stable range. For example, let us consider a positive shift in the medium term inflation rate. In such case, the fluctuation range of interest rates will also shift accordingly and this will result in trigger levels being adjusted. In case, the portfolio manager does not make these adjustments, he will bet too early on decrease in interest rates and thus, he will under perform with regard to the index. Though interest rates remain mean reverting, the length and amplitude of the cycle will not remain stable always. Going back to the strategy, the trigger levels iU and iL should indicate an imminent reversal in the interest rates trend. If this does not happen and for example, the interest rates keep moving up, then the triggered increase in the active exposure will finally affect the portfolio performance.

Posted Date: 9/11/2012 1:58:41 AM | Location : United States







Related Discussions:- Active management in practice, Assignment Help, Ask Question on Active management in practice, Get Answer, Expert's Help, Active management in practice Discussions

Write discussion on Active management in practice
Your posts are moderated
Related Questions
Q. What are the misstatements? A Misstatement is Inconsequential - If a reasonable person would determine after considering the possibility of further undetected misstatement

The distinct features of CDs are: CD is a document of title to a time deposit and is distinct from conventional time deposit with respect to negotiability and marketability.

Explain contingent exposure and define the advantages of using currency options to manage this type of currency exposure. Answer: Companies may come across a state where they m

What does the "weight" refer to in the weighted average cost of capital? The weight pass on to in weighted average cost of capital refers to the portion of the total capital in

Correlation Among Stock Index Returns Correlation among stock Index Returns can be defined as the extent to which the values of different types of investments move in tandem wi

Due to the complexity of the tasks involved in many projects, communication of responsibility for those tasks is often helped by means of graphical planning techniques.

Valuing Debt Securities Securities which promise to pay its investors a stated rate of interest and return principal amount at the maturity date are known as debt securities.

Q. What do you signify by Cash? Cash :- For the motive of cash management the term cash not only includes cheques, bank drafts, coins, currency, notes, demand deposits with ban

•?Detailed information should form the part of your answer (Word limit 150 to 200 words). Case let 1 This case provides the opportunity to match financing alternatives with the nee

Consider a world with two assets: a riskless asset paying a zero interest rate, and a risky asset whose return r can take values +10% or -8% with equal probability. An individual h