, Volume 85, Issue 0, pp 227-247

Scenario modeling for the management ofinternational bond portfolios

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Abstract

We address the problem of portfolio management in the international bond markets.Interest rate risk in the local market, exchange rate volatility across markets, and decisionsfor hedging currency risk are integral parts of this problem. The paper develops a stochasticprogramming optimization model for integrating these decisions in a common framework.Monte Carlo simulation procedures, calibrated using historical observations of volatilityand correlation data, generate jointly scenarios of interest and exchange rates. The decisionmaker's risk tolerance is incorporated through a utility function, and additional views onmarket outlook can also be incorporated in the form of user specified scenarios. The modelprescribes optimal asset allocation among the different markets and determines bond‐pickingdecisions and appropriate hedging ratios. Therefore, several interrelated decisions are castin a common framework, while in the past these issues were addressed separately. Empiricalresults illustrate the efficacy of the simulation models in capturing the uncertainties of theSalomon Brothers international bond market index.