Abstract
This article introduces a new approach for dealing with the diversification/concentration risk of fixed income assets. Because Government bonds, corporate bonds, and mortgage backed securities constitute a large proportion of the assets of institutional investors in most countries, it is important to be able to determine the number of lines/issuers of such assets, not only for portfolio management but also for risk management purposes. The approach that I introduce shows the dependence of the critical number of lines of fixed income assets on the main interest rate risk and credit risk drivers. Specifically, I examine the importance of volatility risk, force of mean reversion, default risk, recovery risk, and default dependence risk on the critical number of assets in a fixed income portfolio. The methodology in this paper relies on the use of the coefficient of variation for the computation of the critical number of credit-sensitive securities in a fixed income portfolio. To the best of my knowledge, this paper is the first to develop such an approach.
Highlights
While a lot of finance research contributions have addressed, since the seminal work of Markowitz (1952), the question of the diversification of stock portfolios, far fewer research papers have examined the diversification of fixed income portfolios
Because a large proportion of the assets of institutional investors are comprised of fixed income securities in the U.S, in Europe, and in other developed economies, it turns out that a large part of the diversification/concentration risk of these companies is related to fixed income assets
This article provides a new framework for determining the critical number of lines that should constitute the fixed income portfolio of an institutional investor
Summary
While a lot of finance research contributions have addressed, since the seminal work of Markowitz (1952), the question of the diversification of stock portfolios, far fewer research papers have examined the diversification of fixed income portfolios. Starting with the work of Merton (1974), they were expanded, e.g., by Longstaff and Schwartz (1995), who take into account interest rate risk, or by Leland and Toft (1996), who relies on an optimization of the value of the company These contributions do not allow us to deal with the optimal level of diversification of a bond portfolio, contrary to the Vasicek structural approach (see, for instance, Vasicek (1987, 1991, 2002)). The final section provides a general formula for the critical number of fixed income assets and analyzes the dependence of this indicator on the main interest rate (force of mean reversion, volatility) and credit (survival/default probability, recovery, dependence) variables
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