Active management in practice, Financial Management

Assignment Help:

Constant Duration

To improve a buy and hold strategy a constant average duration is imposed for the managed portfolio during the full interest rate cycle. This is done because interest rates follow a mean reversion process. In case interest rates move above their average value, they tend to decline later. In contrast, if the interest rates move below average, then they will rise later.

Initially, consider the level of interest rates fluctuation is at middle range (i0 ) and the average level of index duration is D0.  If the interest rates increase from this level, the duration of index will decline. At the same time, if the portfolio manager matches his portfolio duration to index duration, it will result in replication of index performance. When interest rates move to an upper trigger limit iU, subsequently the manager will bring his portfolio duration to the average level of the index duration D0. By maintaining a constant duration D0 for the bond portfolio till the interest rates move back to their average level i0, the portfolio manager will take an active positive exposure that will be rewarded, given the term structure declines later on. In the case of decline in interest rates from level i0 and with a lower trigger limit iL, an opposite argument can be applied.

The success of above strategy will depend on the assumption that the process involved behind the movement in interest rates is mean reverting. This implies that the interest rates should fluctuate in a reasonably well defined and stable range. For example, let us consider a positive shift in the medium term inflation rate. In such case, the fluctuation range of interest rates will also shift accordingly and this will result in trigger levels being adjusted. In case, the portfolio manager does not make these adjustments, he will bet too early on decrease in interest rates and thus, he will under perform with regard to the index. Though interest rates remain mean reverting, the length and amplitude of the cycle will not remain stable always. Going back to the strategy, the trigger levels iU and iL should indicate an imminent reversal in the interest rates trend. If this does not happen and for example, the interest rates keep moving up, then the triggered increase in the active exposure will finally affect the portfolio performance.


Related Discussions:- Active management in practice

Miller-Orr model, Beta plc sets its minimum cash balance as $1,000.00 & eas...

Beta plc sets its minimum cash balance as $1,000.00 & eastimates the following transaction cost sale/purchase =$12 standrsa deviation =$1,200 per day Interest rate =14.6% p.a or 0

Offshore financial center, Offshore Financial Center It is a location w...

Offshore Financial Center It is a location with banking facilities to accept deposits and make loans in currencies various from the currency's country of origin. Banks located

Walter''s dividend model, explain the assumptions underlying Walter''s divi...

explain the assumptions underlying Walter''s dividend model?

Why are trend analysis and industry comparison important, Why are trend ana...

Why are trend analysis and industry comparison important to financial ratio analysis? Trend analysis assists financial managers and analysts see if a company's current financia

Payback period and irr, To look into the feasibility of a new production sy...

To look into the feasibility of a new production system, K-Pad, the largest P.C. producer in the region, has spent $88,000 on the technical feasibility study. In view of the favora

Exchange rate uncertainty affect firm exchange risk exposure, The exchange ...

The exchange rate uncertainty may not essentially mean that firms face exchange risk exposure. Describe why this may be the case. Answer:  A firm can comprise a natural hedging p

Importance of the government securities markets, Need to Widen and Deepen t...

Need to Widen and Deepen the Government Securities Market The importance of the Government Securities markets can be evaluated from three angles as follows: From the Gove

Advantage to corporation of investing in working capital, What is the prima...

What is the primary advantage to a corporation of investing some of its funds in working capital?  By investing in working capital a firm acquires the liquidity it needs helpin

Federal open market committee, Federal Open Market Committee The princi...

Federal Open Market Committee The principle document making body of the Federal Reserve, the FOMC consists of 7 governors of the Federal Reserve System and 12 Federal Reserve D

List a few types of non-price rationing systems, List a few types of non-pr...

List a few types of non-price rationing systems. (a) Queuing. (b) Favored customers. (c) Rationing coupons.

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