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
Illustrate about the Financial Management Individual businesses face problems dealing with acquisition of funds to carry on their activities and with determination ofoptimum

Pension funds Pension funds offers retirement income in the form of annuities to employees covered by a pension plan. They obtain contributions from employers or employees and

Reacher Technology has consulted with investment bankers and determined the intere Reacher Technology has consulted with investment bankers and determined the interest rate it woul

Public Provident Fund (ppf) The Public Provident Fund (PPF) scheme was started in 1968-69 with the aim to provide a financial instrument to workers in the unorganized sector to

Can you draw Capital asset pricing model with example and explain?????

Entity A is significantly smaller than B in terms of revenue and would not impact LOP's revenue to the same extent. However A earns a noticeably better gross profit margin at 26% a

From a practical point of view, the feasibility of the project for Maribyrnong Council can be divided into three elements which are: logistical, operational and legal issues. First

Select a business with which you are familiar and identify examples of customers using search, experience, and credence quality to evaluate the good or service

a) Definitions of EST and LFT needed in order to explain the differentiation between the terms. The EST of each activity will depend on the LFT of all preceding activities. b) S

Illustrate the audit plans Audit team must be sufficiently familiar and fully briefed by manager and have knowledge of the business or operation such that to be able to carry o