Return enhancement on investment, Financial Management

Return Enhancement can be explained using following heads:

  • Use of a Valuation Model: An investor having access to a bond valuation model can build a bond portfolio from bonds that are designated as mispriced on the low side by the model. A significant point here is - the nature of a bond valuation model is much more technical compared to equities. Further, fungibility or interchangeability between bonds in terms of their risk characteristics is more than that found in equities. In other words, the switches in between bonds that may be suggested by a valuation model have more true arbitrage characteristics than the switches among equities.

  • Options Overwriting: A portfolio manager can enhance the returns of a bond portfolio through options overwriting, which means writing interest rate related calls or puts. The forecast for bonds depends on the timing of long-term interest rates.

  • Minimization of the Value of the Bond Portfolio: The portfolio manager can minimize the value of the bond portfolio while implementing liability funding methods. For example, let us discuss the return enhancement technique while immunizing a single liability. Suppose the problem of the portfolio manager is

                   2417_return enhancement.png

The two constraints the portfolio manager experiences are:

                205_return enhancement1.png

In the above equations Pi denotes price of bond i.

The first constraint results in an asset portfolio composed of only bonds. The second constraint causes the duration of the bond portfolio to match the duration of the liability. This technique of optimization is popularly known as linear programming. Such a problem can be solved in a simple way by using well established algorithms. The portfolio manager has to make sure whether the internal rate of return of the bond portfolio thus constructed is more or less similar to the rate he has used to discount the present value of the liability. If not, the portfolio manager in order to discount the liability must optimize again using the internal rate of return of the earlier optimal portfolio.

An important point here is the choice of the set of bonds over which the optimization will take place. Such set must be homogeneous in terms of quality rating. Otherwise, the optimized portfolio will concentrate just on those bonds that result in higher yields as they are cheap and does not consider their risky nature.

Posted Date: 9/11/2012 2:01:35 AM | Location : United States

Related Discussions:- Return enhancement on investment, Assignment Help, Ask Question on Return enhancement on investment, Get Answer, Expert's Help, Return enhancement on investment Discussions

Write discussion on Return enhancement on investment
Your posts are moderated
Related Questions
Explain the pricing spill-over effect. Suppose a firm operating in a segmented capital market (such as China, for example) decides to cross-list its stock in New York or London.

What is the Ratio uses To compare results over a period of time To measure performance against other organisations To compare results with a target To compare against

This assignment is an analysis of a US publicly-traded company; its common stock could be a prospective investment.  The report is due in Week 10, in needs to be at least 5 pages,

Advantages of Private Mutual Funds It is felt that the entry of private Mutual Funds would encourage competitiveness in the financial sector and promote the existing investment

discuss the applicability of an operating cycle of a vegetable growing business

The following is the existing capital structure of Company XYZ Ltd. Ordinary shares at Shs.10 par 1,000,000 Retained 800,000 12% preference shares Shs.10 par 400,000 16% loan Shs.1

Stock on Tap: Most of the players who invest in these securities are institutions and hence the volumes are high. Considering that these securities are the first choice for ban

Explain the Sovereign Risk Sovereign risk denotes a country imposing exchange restrictions on a currency included in a swap making it expensive, or not possible, for a counterp

Need help with explanations for the answers chosen, not good with math calculations, or explaining the answers, can you help with this.Chapters 6, 8

Given that risk-averse investors demand more return for taking on more risk when they invest, how much more return is appropriate for, say, a share of common stock, than is appropr