Integrated Simulation and Optimization Models for Tracking International Fixed Income Indices
by
Stavros A. Zenios
University of Cyprus, Nicosia, Cyprus - Senior Fellow, The Wharton School, University of Pennsylvania, PA.
Coauthors: A. Consiglio (Dipartimento di Organizzazione Aziendale ed Amministrazione Pubblica - Università della Calabria.)

We address the problem of indexed portfolio management in the international fixed income markets.

In the international setting we must address jointly interest rate risk in each market and exchange rate volatility across markets.

This paper develops integrated simulation and optimization models that address these issues in a common framework.

Monte Carlo simulation procedures, calibrated using historical observations of volatility and correlations, generate jointly scenarios of interest and exchange rates and, thereby, scenarios of holding period returns of the available securities. The decision maker's risk tolerance is incorporated either through a utility function or a (modified) mean absolute deviation function.

The optimization models prescribe asset allocation weights among the different markets and also resolve bond-picking decisions.

Therefore several interrelated decisions may be cast in a common framework. Two models---an expected utility maximization and a mean absolute deviation minimization---are implemented and tested empirically in tracking a composite index of the international bond markets.

Backtesting over the period January 1997 to July 1998 illustrate the efficacy of the simulation models in capturing the interest rate and exchange rate uncertainties, and the power of the optimization models in dealing with uncertainty and tracking effectively the volatile index.

Tracking International Bond Indices

Date received: February 22, 1999

Copyright © 1999 by the author(s). The author(s) of this document and the organizers of the conference have granted their consent to include this abstract in Atlas Conferences Inc. Document # cacq-14.