Italian Treasury Bills: Optimal Diversification of Auction Bids

Abstract

The paper describes a method for selecting prices and quantities at auctions of government securities, with special reference to Italian Treasury bill auctions. As suggested by portfolio selection theory, there are three logically distinct steps: in the first, the joint distribution of stop-out and average auction prices are estimated; in the second, the efficient frontier of price/quantity combinations is obtained; and in the third, the combination of bids that maximizes the individual utility function is chosen. The paper concentrates on the first two steps and, in particular, on the estimation of the inputs needed to identify efficient corner portfolios using the critical-line algorithm proposed by Markowitz. To this end, the predictability of the supply of Italian Treasury bills and of the relationship between the primary and secondary markets for Treasury bills have been assessed. In addition, the information content of yields and implied volatilities in the secondary market for Italian Treasury bonds has been tested. Finally, the diversification procedure has been simulated and an example is given in the Appendix.