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Managing sovereign credit risk in bond portfolios

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  • Bruder, Benjamin
  • Hereil, Pierre
  • Roncalli, Thierry

Abstract

With the recent development of the European debt crisis, traditional index bond management has been severely called into question. We focus here on the risk issues raised by the classical market-capitalization weighting scheme. We propose an approach to properly measure sovereign credit risk in a fixed-income portfolio. For that, we assume that CDS spreads follow a SABR process and we derive a sovereign credit risk measure based on CDS spreads and duration of portfolio bonds. We then consider two alternative weighting methods which are fundamental indexation and risk-based indexation. Fundamental indexation is based on GDP indexation whereas risk-based indexation uses a risk budgeting approach based on our sovereign credit risk measure. We then compare all these methods in terms of risk, diversification and performance. We show that the risk budgeting approach is the most appropriate scheme to manage sovereign credit risk in bond portfolios and gives very appealing results with respect to active management of bond portfolios.

Suggested Citation

  • Bruder, Benjamin & Hereil, Pierre & Roncalli, Thierry, 2011. "Managing sovereign credit risk in bond portfolios," MPRA Paper 36673, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:36673
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    References listed on IDEAS

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    Cited by:

    1. Bruder, Benjamin & Roncalli, Thierry, 2012. "Managing risk exposures using the risk budgeting approach," MPRA Paper 37246, University Library of Munich, Germany.
    2. Heidorn, Thomas & Buschmann, Christian, 2014. "The liquidity reserve funding and management strategies," Frankfurt School - Working Paper Series 210, Frankfurt School of Finance and Management.

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    More about this item

    Keywords

    sovereign credit risk; credit spread; convex risk measure; sabr model; CDS; bond indices; fundamental indexation; risk-based indexation; risk budgeting;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General

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