Srichander Ramaswamy

Managing Credit Risk in a Corporate Bond Portfolio

The author proposes a portfolio selection method to manage market risk and credit risk in a corporate bond portfolio relative to its benchmark. He formulates an optimization problem that minimizes the variance of the loss distribution arising from credit risk with the constraints that the expected return of the portfolio not be below the benchmark and the market risk be identical to the benchmark. Such a problem formulation produces a portfolio that exhibits improved risk–adjusted return characteristics ex ante compared to the benchmark. A practical example illustrates the method.

The Sustainability of Pension Schemes

Poor financial market returns and low long-term real interest rates in recent years have created challenges for the sponsors of defined benefit pension schemes. At the same time, lower payroll tax revenues in a period of high unemployment, and rising fiscal deficits in many advanced economies as economic activity has fallen, are also testing the sustainability of pay-as-you-go public pension schemes. Amendments to pension accounting rules that require corporations to regularly report the valuation differences between their defined benefit pension assets and plan liabilities on their balance sheet have made investors more aware of the pension risk exposure for the sponsors of such schemes. This paper sheds light on what effects these developments are having on the design of occupational pension schemes, and also provides some estimates for the post-employment benefits that could be delivered by these schemes under different sets of assumptions. The paper concludes by providing some policy perspectives.

Reserve Currency Allocation: An Alternative Methodology

This paper provides a quantitative framework for choosing the composition of reserve currencies. Assuming that the central banks performance objectives are defined in terms of ex post returns in different currency numeraires, the currency allocation problem is formulated as a multi-objective optimisation problem. The advantage of the proposed methodology is that it does not require any explicit assumptions about the risk preferences of the central bank or knowledge of the currency numeraire. Using some proxy values for the possible range of ex post returns measured in different currency numeraires, the study shows how the currency allocation problem can be solved. In particular, the proposed method borrows the concept of the degree of satisfaction from fuzzy decision theory and maximises such a function defined on the least favourable return outcome. In this sense, the proposed method differs from standard utility-based approaches which look for solutions that are best on average. The results of the study indicate that central banks on average are dollar-based investors on the basis of current allocations. Further, the study also indicates that if central banks consider an ex post return profile that safeguards the purchasing power of the reserves, then the currency distribution of reserves should more closely resemble the SDR basket.

One-step prediction of financial time series

This paper examines the one-step prediction of financial time series from a binary decision theory perspective. Under the assumption that the decision statistic of the binary hypothesis testing problem is a Gaussian random variable, bounds for the forecasting efficiency of the hypothesis testing problem are derived. When the criterion for forecasting performance is the total return over the investment period, an optimisation problem is formulated to compute an optimally weighted decision statistic for the binary hypothesis testing problem. Numerical results are illustrated using weekly time series of excess return between two US dollar bond portfolios having six months duration difference. In particular, it is shown that, on average, a 27 basis point excess return per annum is possible against a given benchmark by carrying out active duration management.

Global Asset Allocation in Fixed Income Markets

Many global investors are faced with the problem of choosing an appropriate currency allocation of their assets in the capital markets. This paper addresses the asset allocation problem under the assumption that the investment universe is comprised of unhedged risk-free bonds in different countries. In general, the total return arising from holding an unhedged bond portfolio is comprised of two components. One component of the return arises from the bond price changes resulting from yield curve movements and the other component arises from exchange rate fluctuations. In this paper, bond price changes are assumed to be governed by a one factor interest rate term structure model. The return arising from exchange rate changes is extracted by modelling the evolution of exchange rates as a jump stochastic process. The jump process is assumed to occur in the volatility of exchange rate returns. This model is consistent with the empirical evidence that the volatility of currency returns exhibits GARCH behaviour. Using the models that describe the evolution of interest rates and exchange rates, the optimal portfolio allocation problem is solved in a mean-variance setting by Monte Carlo simulation. The out-of-sample performance of the portfolios selected is also presented and is compared against those obtained using other existing methods.

Simulated Credit Loss Distribution

Standard portfolio credit risk models provide an assessment of the potential credit loss that could result from changes to the credit quality of different obligors held in a bond portfolio. In practice, a significant portion of the credit loss can also result from changes to credit spreads that may or may not be directly related to the obligors creditworthiness. Comparison of the simulated credit loss distribution for an investment-grade corporate bond portfolio generated using standard credit risk models and the historical credit loss distribution of a similar portfolio indicates that the two are quite dissimilar. Several modifications can be made to the standard portfolio credit risk model to reduce this discrepancy.

Estimation of the Zero Coupon Swap Yield Curve

The term structure of interest rates plays a central role in the valuation, pricing and management of interest rate dependent securities. In this paper I focus on the application of the B-Spline methodology to construct zero coupon and forward rate curves for the swap market. By allowing the placements of the knot points for the B-splines to be part of the optimisation process it is possible to construct smooth zero coupon curves that do not violate the bid-ask constraints of the market rates/prices observed.