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
Question 1 Swap is an agreement among two or more parties to exchange sets of cash flows over a period in future and What do you understand by swap? Describe its features, kind

Distinguish between Lease and Hire Purchase. What are the circumstances in which each of the system of financing is better than other?

what business organization do you preffer ? service concern,trading concern or manufacturing concern

What is meant by a currency trading at a discount or at a premium in the forward market? Answer:  The forward market includes contracting today for the future purchase or sale o

Government securities are the most important and unique financial instruments in the financial markets of any economy. Government of India Securities (GOI Sec) in

Value Index Numbers The value index number as described earlier is a combination index which combines price and quantity changes. Because of the difficulties experienced in pri

Floor Brokers These people have the responsibility of executing the trades forwarded by the FCMs on the floor of the exchange. They can also trade for their own account. They w

Q. Merits of Wealth Maximization Approach? Merits of Wealth Maximization Approach:- The wealth maximization schema is superior to the profit maximization approach because:

Q. Re-order point - technique of inventory management? Re-order point: - The re-order point is that stock level at which an order should be placed. Mutually the excessive and i

Profit and Loss statement:   The Profit and Loss statement is the primary measure of business performance.  As the name suggests, this particular report measure whether the b