Real Securities and Reinvestment Strategies: Fixed-Income and Inflation-Linked Securities and Structured Products

Paolo Sironi

In this chapter we discuss the importance of simulating the risk–return profile of real investments, as opposed to benchmarks, the definition of total asset value and return, the fair-value concept and how to model fixed-income securities, reinvestment strategies of bonds and structure funds, structured products and inflation-linked securities.

INTRODUCTION

Modern Portfolio Theory refers to the contribution of Harry Markowitz, whose intuitive mean–variance paradigm has permeated portfolio management practices ever since its appearance in the 1950s. Although equity portfolio managers have made extensive use of this method and its derivations, fixed-income traders and derivative desks have made much less use of the theory because it cannot conveniently treat the non-linearity of real securities, or the pull-to-parity characteristics of bonds returns. Thus, portfolio managers seeking optimal mean–variance allocations have often resorted to benchmarks to represent fixed-income and derivatives exposures, potentially missing out on relevant risk management information. These limitations are particularly relevant for long-term investment.

Compared with the early 1950s, modern