CHAPTER 8 Martellini Lecture


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CHAPTER 8 MARTELLINI ACTIVE FIXED INCOME PORTFOLIO MANAGEMENT There are generally two types of active strategies: Trading on interest rate predictions, called Market Timing Trading on market inefficiencies, called Bond Picking MARKET TIMING: TRADING ON INTEREST RATE PREDICTIONS Active portfolio managers make bets on changes in the yield curve or one particular segment of the yield curve. There are three types of bets: 1. Timing bets based on no change in the yield curve 2. Timing bets based on the interest rate level 3. Timing bets based on both slope and curvature movements of the yield curve These bets apply to a: Specific rating class such as the term structure of default rates Systematic bets on bond indices representative of various classes that are based on econometric analysis. These are known as tactical style allocation (TSA) decisions, which make up a modern form of bond timing strategy These bets emphasize the need for building decision making helping tools, which consist in providing portfolio managers with landmarks they can compare their expectations with. They are referred to as scenario analysis tools. For a given strategy, a set of scenarios allows for: 1. the evaluation of the break even point from which the strategy will start making or losing money 2. the assessment of the risk that the expectations are not realized 1
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ANALYZING THE STRATEGY When an investor invests in a fixed income security with a maturity different from his desired holding period, the investor is exposed to either reinvestment risk or capital risk. Riding the yield curve is a method that fixed income portfolio managers traditionally use to enhance returns: When the yield curve is sloping up and is supposed to stay unchanged, it enables an investor to earn a higher return by purchasing fixed income securities with maturities longer than the desired holding period, and then selling them in order to gain a profit from falling bond yields as maturities decrease over time. See Example 8.1 on pages 234-235 of textbook. Key idea of this strategy: The longer the maturity of the bond purchased at the beginning, the higher the return on the strategy. IS THE STRATEGY PERFORMING WELL? Using the expectations theory of term structure, then an upward sloping yield curve shows that future short rates are expected to rise. Therefore, an investor will not earn higher returns by holding long bonds rather than short bonds. Here an investor should expect to earn about the same amount on short term or long term bonds over any horizon. But, in practice, the expectations theory of the term structure may not hold perfectly, and a steep increasing yield curve might mean that expected returns on long term bonds are higher than on short term bonds over a given horizon. TIMING BETS ON INTEREST RATE LEVEL
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This note was uploaded on 04/07/2012 for the course ECONOMICS 101 taught by Professor Tillet during the Spring '12 term at Broward College.

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