Probability Approach in Estimating Value at Risk of Bond Portfolios for Effective Hedging

Abstract

Bond portfolios are growing as the investors like banks, fund managers and institutional investors are more interested in Malaysian Bond market comprises conventional and Islamic (Sukuk) Bonds. The Malaysian Sukuk market has provided greater diversification especially catering to the needs of investors such as Islamic pension funds and Islamic insurance companies which can only invest in Shariah-compliant instruments. As the Sukuk and conventional bonds complement each other in Malaysia, we have chosen from real portfolios framed by popular mutual funds to study the risk management practices adopted by these portfolios and to observe the differences and the reasons for them. The link between duration and price volatility is widely used for managing risk positions and portfolio value protection due to the market volatility which can cause huge losses on large exposures. We have applied standard risk measures of bond portfolios, portfolio duration and portfolio convexity to assess the Value at Risk (VaR) accurately and this will lead to minimum cost of hedging. Fair value hedging requires accurate expected loss, which is arrived at by applying these estimates of duration and convexity. We used Bond funds which invest more than 74% of funds in Islamic Bond or Conventional Bond which are designed and implemented by popular Banks and Mutual funds. These results helped in computing the VaR which subsequently could be hedged with the available financial instruments such as interest rate futures in Bursa derivative market effectively.