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Global asset allocation in fixed income markets

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  • Srichander Ramaswamy
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    Abstract

    Many global investors are faced with the problem of choosing an appropriate currency allocation of their assets in the capital markets. This paper addresses the asset allocation problem under the assumption that the investment universe is comprised of unhedged risk-free bonds in different countries. In general, the total return arising from holding an unhedged bond portfolio is comprised of two components. One component of the return arises from the bond price changes resulting from yield curve movements and the other component arises from exchange rate fluctuations. In this paper, bond price changes are assumed to be governed by a one factor interest rate term structure model. The return arising from exchange rate changes is extracted by modelling the evolution of exchange rates as a jump stochastic process. The jump process is assumed to occur in the volatility of exchange rate returns. This model is consistent with the empirical evidence that the volatility of currency returns exhibits GARCH behaviour. Using the models that describe the evolution of interest rates and exchange rates, the optimal portfolio allocation problem is solved in a mean-variance setting by Monte Carlo simulation. The out-of-sample performance of the portfolios selected is also presented and is compared against those obtained using other existing methods.

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    Bibliographic Info

    Paper provided by Bank for International Settlements in its series BIS Working Papers with number 46.

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    Length: 35 pages
    Date of creation: Sep 1997
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    Handle: RePEc:bis:biswps:46

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    1. Jorion, Philippe, 1985. "International Portfolio Diversification with Estimation Risk," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 58(3), pages 259-78, July.
    2. Robert R. Bliss & Peter Richken, 1996. "Empirical tests of two state-variable Heath-Jarrow models," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, issue Aug, pages 452-481.
    3. Dumas, Bernard, 1990. "Performance of currency portfolios chosen by a Bayesian technique: 1967-1985," Journal of Banking & Finance, Elsevier, Elsevier, vol. 14(2-3), pages 539-558, August.
    4. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(2), pages 177-188, November.
    5. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 12(04), pages 627-627, November.
    6. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, Econometric Society, vol. 60(1), pages 77-105, January.
    7. Peter Ritchken & L. Sankarasubramanian, 1995. "Volatility Structures Of Forward Rates And The Dynamics Of The Term Structure," Mathematical Finance, Wiley Blackwell, Wiley Blackwell, vol. 5(1), pages 55-72.
    8. Heynen, Ronald & Kemna, Angelien & Vorst, Ton, 1994. "Analysis of the Term Structure of Implied Volatilities," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 29(01), pages 31-56, March.
    9. Xu, Xinzhong & Taylor, Stephen J., 1994. "The Term Structure of Volatility Implied by Foreign Exchange Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 29(01), pages 57-74, March.
    10. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, Elsevier, vol. 14(1-2), pages 3-24, February.
    11. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 385-407, March.
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    Cited by:
    1. Ivan Popchev & Irina Radeva, 2004. "Bonds Portfolio Management: Analysis and Application of the Model of Multiperiod Immunization," Economic Thought journal, Bulgarian Academy of Sciences - Economic Research Institute, Bulgarian Academy of Sciences - Economic Research Institute, issue 4, pages 28-43.

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