Non-fully invested derivative-free bond index replication

Iliya Markov, Rodrigue Oeuvray () and Nils Tuchschmid ()

Financial Markets and Portfolio Management, 2013, vol. 27, issue 1, 124 pages

Abstract: The problem we address here is the replication of a bond benchmark when only a fraction of the portfolio is invested for the replication. Our methodology is based on a minimization of the tracking error subject to a set of constraints, namely (1) the fraction invested for the replication, (2) a no-short-selling constraint, and (3) a null-active-duration constraint, the last of which may be relaxed. The constraints can also be adapted to accommodate the use of interest rate and bond futures. Our main contribution, however, is our derivative-free approach to replication, which should prove very useful for managing assets when the use of derivatives is prohibited, for instance, by certain investors. We can, thus, still benefit from replicating a traditional investment in a bond index with a fraction of the portfolio according to our risk appetite. The rest of the portfolio can be invested in alpha-portable strategies. An analysis without the use of derivatives over the period from January 1, 2008 to October 3, 2011 shows that with 70–90 % invested for the replication, the annualized ex-ante tracking error can range from 0.41 to 0.07 %. We use principal component analysis to extract the main drivers of the size of the tracking error, namely, the volatility of and the differential between the yields in the objective function’s covariance matrix of spot rates. These results highlight our contribution of a generic and intuitive yet robust approach to bond index replication. Copyright Swiss Society for Financial Market Research 2013

Keywords: Bond index replication; Derivatives; Tracking error; Optimization; C61; G11; G24 (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://hdl.handle.net/10.1007/s11408-012-0201-6 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:kap:fmktpm:v:27:y:2013:i:1:p:101-124

Ordering information: This journal article can be ordered from
http://www.springer. ... nt/journal/11408/PS2

DOI: 10.1007/s11408-012-0201-6

Access Statistics for this article

Financial Markets and Portfolio Management is currently edited by Manuel Ammann

More articles in Financial Markets and Portfolio Management from Springer, Swiss Society for Financial Market Research Contact information at EDIRC.
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().