Mon, 01/05/2006 - 07:59
A new Edhec paper sponsored by Eurex finds that returns on protective option strategies offer appealing risk reduction properties.
Interest in the use of fixed-income derivatives in asset management has perhaps never been so high. On the one hand, from a pure asset management perspective, historically low levels of long-term yields, combined with the prospect of increases in short-term rates by central banks in Europe as well as in the United States, provide strong incentive for implementing strategies that aim to deliver downside protection by combining a long position in bond markets with a long position in put options.
On the other hand, recent pension fund shortfalls have drawn attention to the risk management practices of institutional investors in general and defined benefit pension plans in particular, and have provided new incentives for institutional investors to use fixed-income derivatives in the management of their liability risk.
In this paper, we examine how standard exchange-traded fixed-income derivatives (futures and options on futures contracts such as the ones traded on Eurex, the world's leading futures and options market for euro denominated derivative instruments) can be included in a sound risk and asset management process so as to improve risk and return performance characteristics of managed portfolios, both from a pure asset management perspective and from an asset-liability management perspective.
Derivatives Strategies in Fixed Income Portfolio Management
In order to assess the different uses and benefits of derivatives in fixed income portfolios in the context of a full-blown numerical experiment, we use the Longstaff-Schwartz multifactor term structure model, which features stochastic volatility of bond prices, to generate stochastic scenarios for asset prices.
We first focus on how the use of options can further improve risk management thanks to their ability to generate non-linear, convex payoffs that offer downside risk protection. More specifically, we consider two standard option strategies, the protective put buying (PPB) strategy that consists of a long position in the underlying asset and a long position in a put option, which is rolled over as the option expires. Because in the context of bond portfolio management protective puts are usually implemented with out-of-the money puts on bonds or futures, we set the strike price to 10% out of the money in our base case. We also perform robustness checks that show that our results hold for various choices of strike price.
Examining the performance statistics leads to the conclusion that the PPB strategy is largely favourable when compared to a simple naked position in the underlying futures contract. In particular, the mean return increases, due to the fact that the put option is exercised in scenarios with strongly negative returns. Consequently, the left tail of the returns distribution is cut off, which increases the mean return. Inspection of the probability distribution functions of annual returns confirms that the PPB strategy has less frequent losses of a given magnitude. Intuitively speaking, one may expect that the cost of purchasing the downside protection will have an impact on the performance. However, the negative effect of paying the option price does not outweigh the benefits of avoiding the most negative drawdowns. In other words, the PPB does under-perform slightly when bond markets are doing well, and outperforms significantly when bond markets are doing poorly.
The previous analysis considered stand alone investments into either the options strategy or the bond futures strategy. We also assess the benefits arising from investing into the option strategy in a portfolio context, as an addition to a simple bond futures strategy and we show that protective option strategies should optimally receive a significant allocation, especially when investors are concerned with minimising extreme risks.
Managing Liabilities with Interest Rate Derivatives
Accelerated by the recent pension fund crisis and the emergence of new regulatory and accounting standards that have induced a heightened level of scrutiny on risk management practices of institutional investors, a paradigm change is currently taking place in asset management that puts the relative performance in relation to the institution's liabilities in the forefront of the decision-making process.
A typical pension plan is exposed to significant interest rate risk emanating from a duration mismatch between assets and liabilities. This exposure is permanent and represents a large, sometimes unacknowledged, strategic bet on interest rates and the mismatch in duration exposes the plan to uncompensated risk. While OTC contracts such as inflation and interest-rates swaps can prove useful in the implementation of liability-matching portfolios, exchange-traded alternatives, such as futures, can be regarded as natural cost-efficient alternatives. In a nutshell, interest rates swaps are naturally fitted for implementing cash-flow matching strategies, which involves ensuring a perfect static match between the cash flows from the portfolio of assets and the commitments in the liabilities, while exchange-traded futures should be the instruments of choice in the implementation of immunization strategies, which allows the residual interest rate risk created by the imperfect match between the assets and liabilities to be managed in a dynamic way.
Because most existing cash and derivatives contracts have duration lower than that of the typical liability streams, the residual shortfall risk faced by institutional investors can be very significant. We assess the usefulness of a newly-issued 30 year bond future, the Buxl futures, for hedging purposes, as part of a liability-matching portfolio designed to minimize shortfall variance. We obtain that the longer duration of this futures contracts leads to significant reduction of the surplus/deficit variance, allowing investors with liability constraints to achieve enhanced matching compared to the case where the Buxl futures is not available. This is reflected in the significant allocations the Buxl futures strategy obtains in typical duration matching portfolios.
We also shows that introducing an option trading strategy such as the PPB strategy can serve as a return enhancer that can help alleviate the burden of additional contributions at times when investors face low levels of long-term bond yields.
Our results show that the non-linear character of the returns on protective option strategies offers appealing risk reduction properties in the pure asset management context. Consequently, such strategies should optimally receive a significant allocation, especially when investors are concerned with minimising extreme risks. In an asset liability management context, we also show that fixed-income derivatives in general, and recently launched long-term futures contracts in particular, offer significant shortfall risk reduction benefits.
The full paper can be found on the Eurex website Academic Research Section.
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