Return enhancement on investment, Financial Management

Assignment Help:

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.


Related Discussions:- Return enhancement on investment

Time series analysis, In Time Series Analysis, we try to identify and deter...

In Time Series Analysis, we try to identify and determine the pattern of changes in the data collected over regular intervals of time. The data collected can be at a periodical int

Pledged-account mortgages (pams), PAMs are so structured that the rep...

PAMs are so structured that the repayments resemble traditional mortgages from the lenders' point of view and resemble GPMs from the borrowers' point of view. Thi

Example of relationship between bond price and time, Illustration    ...

Illustration      Discount bond (5 yr. bond with 10% coupon) (expected rate yield at 12%) Premium bo

What is the de-merger, What is the De-merger This is splitting up of a ...

What is the De-merger This is splitting up of a group into two or more separate bodies. The group is split into separate entities, but the shareholders remain the same. It is o

What is free cash flow, A financial consultant obtains different valuations...

A financial consultant obtains different valuations of my company when it discounts the Free Cash Flow (FCF) as opposed to when it uses the Equity Cash Flow. Is this correct? N

Cash flows from portfolio of us standard mortgages, The cash flows ...

The cash flows from a portfolio of US standard mortgages have the characteristic of being uncertain. The cash flows from the mortgage consists of three comp

Reform in a system, As the meaning of reform in a system, these reforms in ...

As the meaning of reform in a system, these reforms in corporate governance would make effective impacts over the process of audit in the context of auditor requirements and the cl

Define modern approach of financial management, Define Modern Approach of f...

Define Modern Approach of financial management Modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for fina

Determinants of working capital, Q. Determinants of Working Capital? D...

Q. Determinants of Working Capital? Determinants of Working Capital: - The working capital necessity is determined by a large number of factors but generally the following fa

Determine the working capital decision, Determine the Working Capital Decis...

Determine the Working Capital Decision Investment in current assets is a major activitythat a finance manager is engaged in a daily basis. How much inventory tokeep, how much

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd