Final Term Project
Directions: Read the following Case and answer all the questions. Please submit your work to the Dropbox by midnight Sunday CT.
Following is a portfolio consisting of 50 bonds with a market value of $ 99,999,999 as of April 29, 2011:
Table 1: 50-bond Portfolio
| Identifier | Description | Sector | Market Value |
| 003723AA | ABN AMRO BANK NV | Corp. Financials | 1,422,596 |
| 251591AY | DEVELOPERS DIVERS REALTY | Corp. Financials | 644,344 |
| 381427AA | GOLDMAN SACHS CAPITAL II | Corp. Financials | 2,761,546 |
| 58551TAA | MELLON CAPITAL IV | Corp. Financials | 3,102,915 |
| 912810PW | US TREASURY BONDS | Treasury | 804,588 |
| 912810QA | US TREASURY BONDS | Treasury | 7,505,533 |
| 912810QK | US TREASURY BONDS | Treasury | 4,048,097 |
| 912828PA | US TREASURY NOTES | Treasury | 3,378,751 |
| 912828PF | US TREASURY NOTES | Treasury | 20,596,365 |
| 00104BAC | AES EASTERN ENERGY | Corp. Utilities | 1,206,446 |
| 02360XAL | AMERENENERGY GENERATING | Corp. Utilities | 737,343 |
| 165167BS | CHESAPEAKE ENERGY CORP | Corp. Utilities | 880,013 |
| 125896BG | CMS ENERGY | Corp. Utilities | 1,337,697 |
| 665772CE | NORTHERN STATES PWR MINN | Corp. Utilities | 907,113 |
| 797440BM | SAN DIEGO GAS & ELECTRIC | Corp. Utilities | 856,840 |
| FGB08000 | FHLM Gold Guar Single F. 30yr | MBS Agency | 3,040,911 |
| FGB07001 | FHLM Gold Guar Single F. 30yr | MBS Agency | 780,262 |
| FGB06402 | FHLM Gold Guar Single F. 30yr | MBS Agency | 1,004,579 |
| FGB07002 | FHLM Gold Guar Single F. 30yr | MBS Agency | 4,235,068 |
| FGB05403 | FHLM Gold Guar Single F. 30yr | MBS Agency | 1,531,707 |
| FGB06003 | FHLM Gold Guar Single F. 30yr | MBS Agency | 1,537,027 |
| FGB06004 | FHLM Gold Guar Single F. 30yr | MBS Agency | 700,545 |
| FGB05011 | FHLM Gold Guar Single F. 30yr | MBS Agency | 690,585 |
| FNA07098 | FNMA Conventional Long T. 30yr | MBS Agency | 1,014,899 |
| FNA08000 | FNMA Conventional Long T. 30yr | MBS Agency | 1,883,297 |
| FNA05402 | FNMA Conventional Long T. 30yr | MBS Agency | 1,854,853 |
| FNA06402 | FNMA Conventional Long T. 30yr | MBS Agency | 1,311,433 |
| FNA07002 | FNMA Conventional Long T. 30yr | MBS Agency | 2,563,939 |
| FNA05003 | FNMA Conventional Long T. 30yr | MBS Agency | 684,085 |
| FNA05403 | FNMA Conventional Long T. 30yr | MBS Agency | 3,469,103 |
| FNA06003 | FNMA Conventional Long T. 30yr | MBS Agency | 1,715,870 |
| FNA05010 | FNMA Conventional Long T. 30yr | MBS Agency | 843,855 |
| FNA05011 | FNMA Conventional Long T. 30yr | MBS Agency | 1,173,465 |
| GNB04411 | GNMA II Single Family 30yr | MBS Agency | 2,509,580 |
| 91311QAD | UNITED UTILITES PLC | Corp. Industrials | 848,272 |
| 02051PAC | ALON REFINING KROTZ | Corp. Industrials | 630,655 |
| 101137AD | BOSTON SCIENTIFC | Corp. Industrials | 1,656,030 |
| 12527GAA | CF INDUSTRIES INC | Corp. Industrials | 1,499,778 |
| 582834AM | MEAD CORP | Corp. Industrials | 787,191 |
| 651715AF | NEWPAGE CORP | Corp. Industrials | 1,603,501 |
| 723787AG | PIONEER NATURAL RESOURCES | Corp. Industrials | 1,045,275 |
| 749685AQ | RPM INTERNATIONAL INC | Corp. Industrials | 642,823 |
| 784635AM | SPX CORPORATION | Corp. Industrials | 766,621 |
| 915436AF | UPM-KYMMENE CORP | Corp. Industrials | 648,265 |
| 962166AV | WEYERHAEUSER CO | Corp. Industrials | 871,588 |
| 45950KBJ | INTL FINANCE CORPORATION | Gov. Related | 1,198,808 |
| 45905CAA | INTERNATL BANK RECON DEV-GLOBA | Gov. Related | 1,200,080 |
| 46513E5Y | ISRAEL STATE OF-GLOBAL | Gov. Related | 1,911,761 |
| 500769BR | KREDIT FUER WIEDERAUFBAU-GLOBA | Gov. Related | 1,012,672 |
| 500769CH | KREDIT FUER WIEDERAUFBAU-GLOBA | Gov. Related | 941,429 |
Table 2: Asset Class
The benchmark for the manager who has constructed this portfolio is a composite index consisting of one-third each of the Barclays Capital U.S. Treasury index, Barclays Capital U.S. Credit Index, and Barclays Capital U.S. MBS index. First, in regards to the Barclays Capital U.S. Treasury index, this index measures the performance of U.S. Treasury securities. Second, in regards to the Barclays Capital U.S. Credit Index, this index includes both corporate and non-corporate sectors where the corporate sectors are industrial, utility, and finance that include both U.S. and non-U.S. corporations. The non-corporate sectors are sovereign, supranational, foreign agency, and foreign local government. The index is calculated monthly on price-only and total-return basis. All returns are market value-weighted inclusive of accrued interest. Third, in regards to the Barclays Capital U.S. MBS index, this index measures the performance of investment grade fixed-rate mortgage-backed pass-through securities of GNMA, FNMA, and FHLMC.
| Asset Class | Portfolio | Benchmark |
| Total | 100.0 | 100.0 |
| Treasury | ? | 33.3 |
| Government Related | ? | 6.8 |
| Corporate Industrials | ? | 13.9 |
| Corporate Utilities | ? | 2.9 |
| Corporate Financials | ? | 9.7 |
| MBS Agency | ? | 33.3 |
Table 3.1: Analytics for the 50-bond Portfolio and the Benchmark
Table 3.1 provides information about the relative exposure to interest rate risk as measured by duration, spread risk as measured by spread duration, and call/prepayment risk as measured by vega, as well as the convexity.
| Analytics | Portfolio | Benchmark | Difference |
| Duration | 6.87 | 5.37 | 1.50 |
| Spread Duration | 6.77 | 5.27 | 1.50 |
| Convexity | 0.47 | 0.00 | 0.47 |
| Vega | 0.01 | 0.03 | 0.02 |
| Spread(bps) | 355 | 55 | 300.00 |
Table 3.2: Contribution to Duration by Asset Class for the 50-bond Portfolio
Table 3.2 provides information about the portfolio’s relative risk exposure to interest rate risk.
| Duration Contribution | Portfolio | Benchmark | Difference |
| Total | 6.87 | 5.37 | 1.50 |
| Treasury | 3.62 | 1.78 | 1.84 |
| Government Related | 0.92 | 0.41 | 0.51 |
| Corporate | 1.10 | 1.74 | –0.63 |
| Securitized | 1.23 | 1.45 | –0.22 |
Table 4: Monthly Tracking Error for Risk Factors
| Risk Factor Categories | Isolated Risk/Tracking Error |
| Curve | 40.8 |
| Swap Spreads | 2.5 |
| Volatility | 2.8 |
| Spread Government Related | 5.3 |
| Spread Corporate | 30.6 |
| Spread Securitized | 5.8 |
Table 5: Volatility table.
This table provides the breakdown of the standard deviation of the returns for the portfolio and the benchmark
| Volatility | Portfolio | Benchmark | Tracking Error |
| Systematic | 141.9 | 117.4 | 37.9 |
| Idiosyncratic | 19.3 | 4.8 | 18.7 |
| Total | 143.2 | ? | ? |
| Duration Beta | ? |
Table 6: Detailed Monthly Tracking Error for the 50-Bond Portfolio by Risk Factor Group
The “risk factor group” table provides information about the portfolio risk across the different categories of risk factors. Shown are the systematic risk and the idiosyncratic risk and six components of systematic risk. The “contribution to TEV” column shows the isolated tracking error. The contribution to tracking error for each group of risk factor is shown in the “liquidation effect on TEV” column.
| Risk Factor Group | Isolated TEV | Contribution to TEV | Liquidation Effect on TEV | TEV Elasticity (%) |
| Total | 42.3 | 42.3 | –42.3 | 1.0 |
| Systematic Risk | 37.9 | 33.2 | –22.4 | 0.8 |
| Curve | 40.8 | 23.4 | –4.3 | 0.5 |
| Swap Spreads | 2.5 | 0.2 | –0.1 | 0.0 |
| Volatility | 2.8 | 0.5 | –0.4 | 0.0 |
| Spread Government Related | 5.3 | 0.0 | 0.3 | 0.0 |
| Spread Corporate | 30.6 | 10.0 | 0.8 | 0.2 |
| Spread Securitized | 5.8 | –0.8 | 1.1 | 0.0 |
| Idiosyncratic Risk | 18.7 | 9.1 | –4.2 | 0.2 |
Questions
The purpose of this project is to describe in detail the risk characteristics of the 50-bond Portfolio. Your instructor drew up the following list of questions that should be covered to be able to discuss the portfolio’s risk relative to the benchmark. In your analysis, be sure to discuss where it seems like the manager is taking views on the market.
1. Use the data in Table 1 to calculate the missing weights for each class asset that appear in Table 2. After completing the missing weights, start your analysis of table 2 by comparing the portfolio to that of benchmark in terms of the allocation to the major sectors of the benchmark (i.e., overweighting/underweighting). Discuss your results.
2. Do you think the portfolio manager can use the percentage allocation to each sector (i.e., Asset class table) to evaluate the portfolio’s exposure to various risk factors? Explain?
3. Use the data in Table 3.1 and 3.2 to assess the portfolio risk relative to the benchmark? Make sure to discuss the sources of risk (i.e., interest rate risk, spread risk, and call & prepayment risk). Before starting your analysis, explain the differences among interest rate risk, spread risk, and call & repayment risk.
4. What is tracking error? What is meant by tracking error due to systematic risk factors? What is meant by isolated tracking error? Briefly explain what is meant by yield curve risk, swap spread risk, volatility risk, government-related spread risk, corporate spread risk, and securitized spread that are listed in table 4 and the (monthly) volatility of these risk factor categories?
5. Compute the isolated systematic tracking error for the portfolio given the monthly tracking error for each risk factor exposure in Table 4? Discuss the implications of your results for the risk exposure of this portfolio. Make sure to assume a zero correlation between any pair of risk factors when calculating the portfolio isolated systematic tracking error.
6. Why is the tracking error more important than portfolio variance of returns when a portfolio manager’s performance is measured versus a benchmark?
7. You are reviewing table 5 that indicates that a portfolio tracking error is 143.2 basis points. It is also reported that the tracking error due to systematic risk is 141.9 basis points and the tracking error due to non-systematic risk is 19.3 basis points. Why doesn’t the sum of these two tracking error components total up to 161.2 basis points?
8. Calculate the total risk for the benchmark using the values in the “volatility” Table (i.e., Table 5) and portfolio tracking error (volatility of net position). Complete the related blank in Table 5.
9. How can a multi-factor risk model be used to monitor and control portfolio risk? Explain whether you agree or disagree with the following statement “It is the tracking error not the idiosyncratic risk (as measured by the standard deviation of the idiosyncratic returns) that the manager must consider in portfolio construction and monitoring”. Use Table 5 to support your argument.
10. Compute the duration beta using the values in the “analytics” table (Table 3.1). Complete the related blank in Table 5. Explain your answer.
11. Based on the information given in Table 6, what are the major risk exposures of the 50-bond portfolio? Explain your answer.
