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Managing sovereign credit risk in bond portfolios

Author

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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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    File URL: https://mpra.ub.uni-muenchen.de/36673/1/MPRA_paper_36673.pdf
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    References listed on IDEAS

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    1. Antonio Cesare, 2006. "Do Market-based Indicators Anticipate Rating Agencies? Evidence for International Banks," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 35(1), pages 121-150, February.
    2. Blake, Christopher R & Elton, Edwin J & Gruber, Martin J, 1993. "The Performance of Bond Mutual Funds," The Journal of Business, University of Chicago Press, vol. 66(3), pages 370-403, July.
    3. Victor DeMiguel & Lorenzo Garlappi & Raman Uppal, 2009. "Optimal Versus Naive Diversification: How Inefficient is the 1-N Portfolio Strategy?," Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1915-1953, May.
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    5. Carmen M. Reinhart & Kenneth S. Rogoff, 2014. "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," Annals of Economics and Finance, Society for AEF, vol. 15(2), pages 1065-1188, November.
    6. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Varieties of Crises and Their Dates," Introductory Chapters,in: This Time Is Different: Eight Centuries of Financial Folly Princeton University Press.
    7. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    8. Francis A. Longstaff & Jun Pan & Lasse H. Pedersen & Kenneth J. Singleton, 2011. "How Sovereign Is Sovereign Credit Risk?," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(2), pages 75-103, April.
    9. Jens Hilscher & Yves Nosbusch, 2010. "Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt," Review of Finance, European Finance Association, vol. 14(2), pages 235-262.
    10. Roncalli, Thierry, 2010. "Understanding the Impact of Weights Constraints in Portfolio Theory," MPRA Paper 36753, University Library of Munich, Germany.
    11. Richard Cantor & Frank Packer, 1996. "Determinants and impact of sovereign credit ratings," Economic Policy Review, Federal Reserve Bank of New York, issue Oct, pages 37-53.
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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.

    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;

    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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