For an unleveraged total return manager, many of the proposals are similar. It is
again efficient to focus mainly on parallel and slope risk when setting interest rate
risk limits, implementing an interest rate view, or designing hedging strategies. This
greatly simplifies interest rate risk management, freeing up the portfolio manager’s
time to focus on monitoring other forms of risk, on assessing relative value, and on
carrying out more detailed scenario analysis.
Many analytics software vendors, such as CMS, provide measures of slope risk.
Investment managers should ensure that such a measure satisfies two basic criteria.
First, it should be consistent with the results of a principal component analysis: a
measure of slope risk based on an unrealistic slope shift is meaningless. Second, it
should be easy to run, and the results should be easy to interpret: otherwise, it will
rarely be used, and slope risk will not be monitored effectively.
The above comments on risk management of global bond positions apply equally
well in the present context. However, there is an additional complication. Global
bond investors tend to have some performance benchmark, but it is most unclear
how an ‘optimal’ benchmark should be constructed, and how risk should be measured
against it. For example, some US investors simply use a US domestic index as
a benchmark; many use a currency unhedged global benchmark. (Incidentally, the
weights of a global benchmark are typically determined by issuance volumes. This is
somewhat arbitrary: it means that a country’s weight in the index depends on its
fiscal policy and on the precise way public sector borrowing is funded. Mason has
suggested using GDP weights; this tends to lower the risk of the benchmark.)
Figures 5.14(a)–(c) may be helpful. They show the risk/return profile, in USD
terms, of a US domestic bond index; currency unhedged and hedged global indexes;
and the full range of post hoc efficient currency unhedged and hedged portfolios.
Results are displayed separately for the 1970s, 1980s and 1990s datasets. The first
observation is that the US domestic index has a completely different (and inferior)
risk/return profile to any of the global portfolios. It is not an appropriate benchmark.
The second observation is that hedged and unhedged portfolios behave in completely
different ways. In the 1970s, hedged portfolios were unambiguously superior;
in the 1980s, hedged and unhedged portfolios behaved almost like two different asset
types; and in the 1990s, hedged and unhedged portfolios seemed to lie on a continuous
risk/return scale, with hedged portfolios at the less risky end. If a benchmark
is intended to be conservative, a currency hedged benchmark is clearly appropriate.
What, then, is a suitable global benchmark? None of the post hoc efficient portfolios
will do, since the composition of efficient portfolios is extremely unstable over time –
essentially because both returns and covariances are unstable. The most plausible candidate is the currency hedged global index. It has a stable composition, has
relatively low risk, and is consistently close to the efficient frontier.
Once a benchmark is selected, principal component analysis may be applied as
follows. First, it identifies countries which may be regarded as particularly risk
relative to the benchmark; in the 1970s and 1980s this would have included Australia
and France (see Figure 5.11). Note that this kind of result is more easily read off from
the analysis than by direct inspection of the correlations.
Second, it helps managers translate country-specific views into strategies. That it,
by estimating the proportion of yield shifts attributable to a global parallel shift
(around 50% in the 1990s) it allows managers will a bullish or bearish view on a
specific country to determine an appropriate degree of overweighting.
Third, it assists managers who choose to maintain open currency risk. A more
extensive analysis can be used to identify ‘currency blocs’ (whose membership may
vary over time) and to estimate co-movements between exchange rates and bond
yields. However, all such results must be used with great caution.
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