Question 6 Having studied Fixed Income Securities, you are now working as an analyst for a well known bond fund. Your manager asks you to replicate the JP Morgan T-Bond Index using a tracking error minimization approach. You are to replicate this index as closely as possible using a medium duration Treasury bond (M-BOND) and a long duration Treasury bond (L-BOND). These expire in approximately 7.15 years’ and 29.25 years’ time respectively. The following variance-covariance matrix, based on daily returns over the preceding six months, is given to you to use in your replication: Note: As usual, variances are given on the diagonal, e.g. the variance of M-BOND is 0.0042%. As usual, covariances appear in the non-diagonal elements, e.g. the covariance of M-BOND and L-BOND is 0.0057%. (a) Suppose the optimal weights for M-BOND and L-BOND are 0.7 and 0.3. Calculate the expected tracking error of the portfolio and explain how you interpret this number. (b) Calculate the correlation matrix corresponding to the variance-covariance matrix above. Also calculate the correlation between the optimal replicating portfolio in part (a) and the index. Briefly comment on your results.
Question 6 Having studied Fixed Income Securities, you are now working as an analyst for a well known bond fund. Your manager asks you to replicate the JP Morgan T-Bond Index using a tracking error minimization approach. You are to replicate this index as closely as possible using a medium duration Treasury bond (M-BOND) and a long duration Treasury bond (L-BOND). These expire in approximately 7.15 years’ and 29.25 years’ time respectively. The following variance-
Note: As usual, variances are given on the diagonal, e.g. the variance of M-BOND is
0.0042%. As usual, covariances appear in the non-diagonal elements, e.g. the
covariance of M-BOND and L-BOND is 0.0057%.
(a) Suppose the optimal weights for M-BOND and L-BOND are 0.7 and 0.3. Calculate the expected tracking error of the portfolio and explain how you interpret this number.
(b) Calculate the
Step by step
Solved in 3 steps with 2 images
