Stanford University Finance Fall 2012 Bond Portfolio Management Project Instrucor: Kay Giesecke

Team: Zurich Lions Velican Usta & Yefreed Ditta

A. Part 1
Step 1. Price Adjustment
Prices of the bonds were adjusted by calculating first the decimal part and adding that to the price, and then the next step was to calculate the accrued interest:
Accrued Interest = Days elapsed since last maturity * Coupon / Days in a year

Results are shown in column F in the FrontEnd worksheet (Appendix A.1).

Step 2. Spot Rates using Zero Coupon Bonds

To construct the spot curve zero coupon bonds are constructed per maturity (except 15.02.2013 where the averages of two bonds were used). The amount of bonds per maturity was determined by selling 1 bond (the one with the higher coupon rate in the period) and buying n bonds of the ones with the lower coupon rate, where n is the result of dividing the higher coupon rate by the lower. Having this in mind is clear that the face value F of the zero coupon bond is: F = (n-1)*100 And todays price normalized to 100 is: P = (n*price of 1st bond price of 2nd bond)/ (n-1) Using continuous compounding, D (t) = e r (t) t (3) (2) (1)

Since the coupon payments cancel each other, the only cash flow will be the face value at the end of the period, hence: P = F * D (t) Replacing (3) in (4) = = = ln = (5) (4)

Team: Zurich Lions Velican Usta & Yefreed Ditta For the first spot rate calculation (15.02.2013), the average of the two bonds are taken into account, using the dirty price of the bond as P and the last payment at the maturity date as F in (5): P = dirty price including accrued interest F = 100*(1+coupon rate/2) The respective rates are averaged afterwards. Results are in the FrontEnd worksheet (Appendix A.2).

Step 3. Spot Rates using a 4th Order Polynomial

The term structure of interest rates are approximated by a 4th order polynomial of the form: r(tj) = a0 + a1*tj + a2* tj2 + a3* tj3 + a4* tj4 The coefficients are estimated by minimizing the square of the price differences: minimize

(P

Q j )2

where Pj: dirty price of the bond Qj: NPV of the bond The calculations of the NPV of the bonds (Appendix A.3) uses the discount factors which include the rates approximated by the 4th order polynomial. The results are in the FrondEnd wosksheet (Appendix A.3). Using these NPVs and the dirty prices, the sum of the squared errors are then minimized using the Solver function of MS Excel (Appendix A.3). The resulting coefficients are: a0=0,a1=0.001233,a2=0.000852, a3=-0.000479, a4= 0.000075

Step 4. Plots of Term Structure

Figure 1.1 Term Structure Plots

Team: Zurich Lions Velican Usta & Yefreed Ditta The first method is straightforward however gives increasing and decreasing trends in the spot rate curve which is not realistic as the expected interest rate to invest money in longer periods should be higher than the shorter periods that the spot rate curve is expected to be strictly increasing. The first method is sensitive to the different bonds as the characteristics of the bonds for each maturity date may differ from one another, therefore it is more advantageous to use an average method such as the polynomial approximation as in the second method.

B. Part 2
Step 5A. Simple Cash Matching
The total cost of the portfolio is minimized, with the number of bonds purchased as variables: minimize

Pi , where xi is the number and Pi is the price of ith bond.

The constraints are that the liabilities must be exceeded by the total cash flows at each maturity date and the number of bonds purchased must be grater than or equal to 0. The results (cash flows and the portfolio) are in the CashMatchFront worksheet (Appendix B.1).

Step 5B. Complex Cash Matching

In this step, the same approach is used as in step 5A, with an additional setting that the excess cash flow at each payment date can be reinvested at the forward rates which are computed using a continuous compounding and between two consecutive due dates:

f t1 t 2 =

st 2 t2 st1 t1 t2 t1

The excess cash flow is reinvested using the forward rates between two consecutive dates using a half-year compunding as it is assumed that the reinvestment instrument will be the purchase of bonds which make payments in half-year periods. The cash flow at time t2 resulting from the reinvestment at time t1 is: CFt2 = (Excess Flow)t1* (1 + f12/2) This cash flow is added to the cash flow resulting from the payments and coupons. The results (forward rates, cash flows and the portfolio) are in the CashMatchFront worksheet (Appendix B.2).

Step 6. Portfolio Immunization

The present value of the total cash flow is:

PV = CFti e ( a0 +a1ti +a2 ti

+ a3 ti 3 + a4 ti 4 )ti

Setting the functions y(u) = e-u ( y is the discount rate),

Team: Zurich Lions Velican Usta & Yefreed Ditta

2 3 4

and u(ai) =

( a 0 + a1 t i + a 2 t i + a 3 t i + a 4 t i ) t i

Utilization of the chain rule gives:

dy dy du = dai du dai
The terms

dy for each derivative is the same which is e-u (the discount rate multiplied with -1). du

Using this rule, the derivatives of the present value of the portfolio with respect to the polynomial coefficients are:
2 3 4 dPV = CFti e ( a0 + a1 ti + a2 ti + a3 ti + a4 ti )ti (t i ) da0

2 3 4 dPV 2 = CFti e ( a0 + a1ti + a2 ti + a3 ti + a4 ti )ti ( t i ) da1

2 3 4 dPV 3 = CFti e ( a0 + a1ti + a2 ti + a3 ti + a4 ti )ti ( t i ) da 2

2 3 4 dPV 4 = CFti e ( a0 + a1ti + a2 ti + a3 ti + a4 ti )ti ( t i ) da3

2 3 4 dPV 5 = CFti e ( a0 + a1ti + a2 ti + a3 ti + a4 ti )ti ( t i ) da 4

The first constraint is that the PV of the cash flows are equal to that of liabilities. The immunization formula (given the fact that the PVs are equal) results in the constraints that the derivatives are also equal for cash flows and liabilities. The next step is to set the constaints for 5 cases: 1) 2) 3) 4) 5) Equalize PV and dPV/da0 Equalize PV, dPV/da0 and dPV/da1 Equalize PV, dPV/da0, dPV/da1 and dPV/da2 Equalize PV, dPV/da0, dPV/da1, dPV/da2 and dPV/da3 Equalize PV, dPV/da0, dPV/da1, dPV/da2, dPV/da3 and dPV/da4

Each case includes the minimization objective of the total number of bonds and the constraint that the number of bonds purchased are greater than or equal to 0 for each bond. The results are in the DurationFront worksheet (Appendix B.3). The portfolio constructed in this step is immunized against changes in the spot rates whereas this is not the case for the portfolios of steps 5A and 5B. Once the interest rates change, the present values of the immunized portfolio and the cash obligation will both respond in the same way. This is the

Team: Zurich Lions Velican Usta & Yefreed Ditta advantage of the immunized portfolio over the portfolios with present value matching. Moreover as a natural result of this method, there is not a need anymore to match the present values of each cash stream and the portfolio. Different cases immunize the portfolio against different kinds of changes in interest changes. Case 1 immunizes the portfolio against parallel shifts in the spot rate curve in the vertical axis (Figure 2.1) which was covered in the lecture.

Figure 2.1 Parallel shifts in spot rates: with respect to a0 To illustrate other shapes of the shifts in the spot rate curve, below is the change of spot rates for 3 representative a1 values (Figure 2.2).

Figure 2.2 Representative shift in the spot rate curve: with respect to a1 In both graphs, the blue curves represent the spot rates with optimal a0 and a1.

Team: Zurich Lions Velican Usta & Yefreed Ditta

Appendix A
A.1 Results: Bond Prices with Accrued Interest

Figure A.1 Adjusted bond prices (FrontEnd Worksheet)

Team: Zurich Lions Velican Usta & Yefreed Ditta

A2. Results: Spot Rates using Zero Coupon Bonds

Figure A.2 Spot rates using the zero coupon bonds (FrondEnd worksheet)

A.3 Results: NPV of Bonds using 4thOrder Polynomial

Figure A.3 NPV of Bonds using 4thOrder Polynomial-after optimization (FrontEnd worksheet)

Team: Zurich Lions Velican Usta & Yefreed Ditta

Figure A.3 Detailed results coefficient estimation (FrontEnd worksheet)

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Appendix B
B.1 Results: Simple Cash Matching

Figure B.1 Cash flow of the resulting portfolio without reinvestment

Team: Zurich Lions Velican Usta & Yefreed Ditta

Figure B.2 Portfolio without reinvestment

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B.2 Results: Complex Cash Matching

Figure B.3 Forward rates of two consecutive due dates & cash flow of the resulting portfolio with reinvestment

Team: Zurich Lions Velican Usta & Yefreed Ditta

Figure B.4 Portfolio with reinvestment

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B.3 Results: Portfolio Immunization

Figure B.5 Immunization of the portfolio for 5 cases