10-year U.S. government bond yield to model interest rate risk while the other consultant
used the 30-year U.S. government bond yield, their computed VARs could be very different.
Level III: Question 16
Topic: Global Fixed Income
Minutes: 12
Readings:
“International Bond Portfolio Management,” Ch. 26, Christopher B. Steward and J. Hank Lynch,
Managing Fixed Income Portfolios, Frank J. Fabozzi, ed. (Frank J. Fabozzi Associates, 1997)
Purpose:
To test the candidate’s understanding of the effect of the currency hedging policy on the risk and
return objectives of an international bond portfolio.
LOS: The candidate should be able to
“International Bond Portfolio Management” (Session 10)
• discriminate between a domestic bond portfolio manager’s challenges and an international bond
portfolio manager’s challenges by citing specific common responsibilities and responsibilities
that differ.
• discuss the fundamental steps in the investment process—setting objectives, establishing
investment guidelines, developing portfolio strategy, constructing the portfolio, monitoring risk,
and evaluating performance—as they apply to domestic and international bonds.
Guideline Answer
A. A fully-hedged international bond portfolio strategy offers better risk reduction for domestic
investors because of the lower standard deviation of returns in home currency terms. That is, it
offers greater assurance of achieving an accurately estimated return in domestic currency terms.
However, a fully-hedged portfolio forfeits the potential performance enhancement from
successful active currency management. Depending on the nature of inter-bond correlations,
even a partially-hedged strategy offers the potential for some return enhancement while
preserving some diversification benefits.
B. Jacob’s decision to fully hedge his portfolio contradicts the fund’s objectives. The fund has
aggressive return objectives and high tolerance for risk. Eliminating the ability to add value
through active currency management is counter to the return objective, and pursuing a strategy
that attempts to eliminate currency risk entirely is counter to the risk tolerance objective.
Level III: Question 17
Minutes: 14
To test the candidate’s understanding of the limitations of duration as a portfolio measure of interest
rate sensitivity and the potential sources of excess return in international bond portfolio
management.
“International Bond Portfolio Management” (Session 10)
that differ;
and evaluating performance—as they apply to domestic and international bonds;
• compare and contrast five broad strategies: currency selection, bond selection, duration
management, sector/credit/security selection, and outside-benchmark investing.
A. The consultant is incorrect in suggesting that the weighted-average portfolio duration
calculation is the same for both global and domestic bond portfolios. The portfolio duration
measure for international bond portfolios is far more limiting than for domestic portfolios. A
domestic portfolio’s duration can equal the weighted sum of its individual securities’ durations
when all the yields and corresponding term structures are the same. An international portfolio’s
total duration, however, will rarely be equal to a simple sum of the duration-weighted
components, because interest rate movements in different countries are not perfectly correlated.
Also, the differing volatility of interest rates across markets means that the contribution to
duration from a given market is not entirely comparable to that of another market. Finally, the
yield curve structures and yields on the constituent bonds are also different across markets.
B. Additional sources of excess return in global bond management are:
• Bond Market Selection/Country Selection. By correctly over or underweighting the best and
worst performing countries/markets, the added return can be large and is arguably the largest
source of potential excess return.
• Sector/Issue Selection. Investing in corporate and other non-government issues can add
incremental value. However, these bonds are not as widely available in many markets as in
the U.S. and other developed markets.
Level III: Question 18
Topic: Portfolio Management - Derivatives (Study Session 17)
Minutes: 22
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