Corporate Fin Mgt NDLM.PDF

The other way to achieve the target beta and duration is to adjust the composition of the
portfolios within each asset class. For example, we can say that while investing 90% of
our portfolio in equities, we will choose our equity portfolio in such a way as to ensure an
average beta of 1.25. This will give an overall beta of 0.9 X 1.25 = 1.125. Similarly
while saying that we will invest a certain percentage of our portfolio in bonds, we can
also say that we will choose long maturity bonds so as to obtain a duration of 5 years for
the bond portfolio.

In case of institutional investors, it is not uncommon for each of the three asset classes to
be managed by different individuals almost independently. In such cases, the asset
allocation process is the crucial stage at which their actions are coordinated by taking an
integrated view of the total portfolio. The person in charge of each asset class will be
told not only what quantum of the total funds are being allocated to him, but also what is
the average duration and beta expected from him. For example, the fact that a fraction of
the total portfolio is invested in stocks increases the average duration of the total portfolio
and allows the investor to have a lower duration for the bonds portfolio than if the entire
portfolio were invested in bonds. To control the risk better, the bond portfolio manager
needs to know the duration of the stock portfolio, and the equity portfolio manager needs
to know that his actions may be changing the duration of the total portfolio. For some
investors like pension funds and life insurance companies (which are, in India, in the
public sector), the desired duration is far longer than what is available in bond markets.
For them, the equity portfolio is the principal route to achieving high duration. We
normally think of equities as being risky, here, however, equities become an instrument
of risk reduction!

Example 2

How can an investor achieve target duration of 10 years if most corporate bonds have
duration of only 5 years?

Solution

The investor will not want to invest in government bonds and other low-yielding
securities even if they have a long duration. But he can use equities (which would have
an average duration of about 30 years) to achieve his target duration as shown in the
following asset allocation:

Asset Class Duration Percentage

Allocation

Duration Times

Allocation.

Corporate Bonds 5 80% 4

Equities 30 20% 6

Duration 10

In those cases where all three asset classes are being managed by the same individual, the
process of asset allocation is not always as clearly differentiated from the second stage of