Security modelling

Security modelling

Can I define my own pricing functions to be used in FIA?

Yes. See the sections on OpenPricing.

Can I define my own risk functions to be used in FIA?

Yes. See the sections on OpenRisk.

This need might arise if, for instance, mortality derivatives include a new type of risk (mortality distributions) that is not included in any of the standard risk approaches.

If you set up a 'Mortality' source of return, this will appear on your attribution reports in the same way as all other portfolio risks.

Can I mix and match pricing models?

Yes. You can use different pricing functions for the same types of security. You can even change the way a security is treated over time by using the effective data functionality.

Why should I expect residuals from futures contracts?

Futures contracts always generate larger residuals than one might expect given their apparent simplicity and liquidity.

How does FIA handle changes in the CTD (cheapest to deliver) bond for a futures contract?

By using the effective date fuctionality.

The cheapest-to-deliver bond for a bond futures contract changes over time. If the CTD bond has changed during the lifetime of a contract, simply change the maturity date and coupon of the futures instrument at the appropriate effective date to match the updated CTD bond.

Does FIA need cash offsets to model interest rate futures?

Some performance systems can only accurately model an interest rate future if a cash holding equal and opposite to the market exposure of the underlying bond is included in the portfolio holding. This allows the system to model the zero effective exposure of the futures contract and to treat the future as an equivalent holding of the CTD (Cheapest To Deliver) bond for that future (but note the comments below on carry return for futures).

FIA allows futures contracts to be modelled with or without cash offsets, depending on how the portfolio holdings data is supplied.

How does one calculate carry return on a futures contract?

A bond futures contract is treated slightly differently to a bond. The carry return is adjusted by subtracting the current repo rate from the yield to maturity of the underlying CTD bond, to reflect the financing costs of the futures contract.

How does FIA treat Australian and New Zealand bond futures?

The Australian and New Zealand markets treat futures on bonds slightly differently to other countries. Since the maturity of the underlying bond is always a constant, set interval, there is no carry return from this asset class. The return of an Australian or New Zealand bond future is therefore given by

−MD × δy

and FIA treats these securities as a special case.

How do I set up a vanilla interest rate swap?

An interest rate swap can be modelled as a combination of a bond and an FRN, where the face value of the FRN is equal and opposite to that of the bond.

In FIA, the options are as follows:

  • Set up the swap as a long bond holding and a short FRN holding. The swap’s two legs can either be regarded as part of the portfolio, or they can be placed in a subportfolio that has the name of the swap. The swap’s exposure and attribution returns then be shown as a single instrument in the portfolio’s attribution report. This is the most accurate way to model a swap.
  • Set up the swap as a single-leg security. This may be appropriate for cases where only the maturity date and fixed coupon of the swap are available. In this case, model the swap as a bond and assign its residuals to one of its existing return categories such as ’duration’. This is not particularly accurate but will at least assign the swap’s return to where you expect it.

How do I set up a total return swap?

A total return swap exchanges the total return on an asset for a set of periodic cash flows, either fixed or floating.

The treatment of the swap depends on the nature of the underlying asset. If it is an equity (which generates cash flows plus capital gains or losses) then the reference leg should be set up as type EQUITY, with return given by the total return of the asset. If it is a bond, then the TRS may be set up as a vanilla interest rate swap, but the extra return generated by the bond’s coupons may be placed in a special ’TRS excess’ residual category.

How do I set up a currency swap?

A currency swap exchanges principal and interest for a bond in one currency for a bond in another. To set up a currency swap, use two bonds in different currencies with the same maturity date and equal but opposite face values.

How do I set up a forward contract?

In attribution, a forward contract usually means an FX contract which is used for hedging. Such a forward can be modelled as two bank bills with the same maturity dates and equal but opposite face values.

How does one run attribution on an inflation linked bond?

Inflation-linked (or IL) bonds differ from vanilla bonds in two vital respects:

  • Their coupons and principal are inflation-indexed
  • Their cash flows should be discounted using the real yield curve, not the zero curve.

For an attribution system, this requires that a separate real yield curve be provided for this asset types. In addition, historical values of the relevant CPI index must also be supplied so that the daily return due to inflation indexation can be calculated, in addition to returns from carry, market and credit (if appropriate).

FIA allows real yield curves to be stored and used in just the same ways as ordinary par and zero curves. Periodic returns are also stored as part of the security definition for inflation-linked securities, and this can be updated at monthly or quarterly intervals as the inflation index changes using FIA’s effective date functionality.

Why does a zero-coupon bond show time return but no accrued interest?

Accrued interest is only generated by coupons, so is never generated by a zero coupon bond. On the other hand, zero coupon bonds are always sold at a discount, so as time passes and maturity approaches their price will rise, generating return.

What’s an easy way to model a callable bond?

Callable bonds can be awkward to model in an attribution framework, because their maturity date is not known in advance. This makes it difficult to model their duration and hence their interest rate sensitivity.

In practice, it is usually fairly clear whether a bond is due to be called. If so, the maturity date should be set to the next call date. Any residual return can then be written to a custom ’Optionality’ return bucket.

Does a CDS have interest rate risk?

Yes, but not very much.

By far the largest return for a CDS is due to changes in the credit rating of the related security, which is usually assigned to credit return. A CDS usually involves a series of relatively small periodic payments over the security’s lifetime to pay for the implied insurance provided. In principle these payments should be discounted at the prevailing rate and included in the calculation of the CDS’s return. In practice, this return is usually so small it can be ignored.

How should a CDS be modelled in an attribution framework?

By far the easiest way is to assign all its return to credit, and this is what FIA does.

How should an FRN be handled in an attribution framework?

Unlike a vanilla bond, an FRN has two interest rate sensitivities: an interest rate duration and a spread duration.

Of the two, interest rate duration contributes very little return. This is because, as interest rates change, the FRN’s coupon is modified so that any return made or lost by such changes is compensated. The net effect is that the price and return of the FRN is relatively insensitive to risk-free curve movements.

The two main drivers of an FRN’s return are its yield (which is driven by coupon payments) and changes in its credit-worthiness. The FRN’s price sensitivity to changes in the credit spread is measured by the spread duration.

However, this quantity may not be available on a daily basis, so the return of the FRN may be approximated by firstly calcuating its yield return, and then assigning the rest of its return to credit spread.