GLOBAL ASSET MANAGEMENT INC. THE USE OF FIXED INCOME DERIVATIVES AT TAL GLOBAL ASSET MANAGEMENT Paul Bourdeau, CFA Page 1 September 2002
AGENDA Overview of TAL Overview of the Use of Derivatives at Use of Fixed Income Derivatives at TAL Hurdles to the Use of Derivatives Risk Management of Derivatives Page 2
TAL GLOBAL ASSET MANAGEMENT VANCOUVER MONTRÉAL TORONTO CAYMAN ISLANDS GENEVA HONG KONG &Founded in 1972 &80 Investment Professionals &$ 58 Billion AUM &Wholly owned by CIBC Page 3
PRODUCT LINE ACTIVE Global Asset Allocation U.S. Equities and Canadian Equities Global Equities European Equities Asian Equities Global Bonds Emerging Market Bonds OVERLAY Customized Asset Mix Overlay Global Asset Mix Overlay International Bond Overlay Currency Overlay PASSIVE Canadian Equity Index U.S. Equity Index International Equity Index (EAFE) Canadian Bond Index Global Bond Index Immunization Currency Hedging ALTERNATIVE STRATEGIES Global Bonds Currency Fund Fund of Hedge Funds Page 4
TAL ASSETS MANAGED USING DERIVATIVES Derivative Assets " Over $12 Billion of underlying assets use derivatives Scope of activities Equity Index Futures " Over 40 contracts in 30 countries Bond Futures and Forwards " Over 15 contracts worldwide Currency Forwards and Options " Over 15 currencies Page 5
HOW DERIVATIVES ARE USED Derivatives are used to implement the managers views " Low transaction cost " High liquidity " Speed of implementation Risk can be managed using derivatives " Leverage " Calibration of risk " Diversification Return can be optimized with derivatives using overlay strategies Page 6
TAL GLOBAL ASSET MANAGEMENT AT TAL, FIXED INCOME DERIVATIVES ARE PRIMARILY USED FOR: GLOBAL ASSET MIX OVERLAY BOND PORTFOLIO BOND OVERLAY Page 7
GLOBAL ASSET MIX OVERLAY Page 8
GLOBAL ASSET MIX OVERLAY K Pension plans typically hire specialized managers in all asset classes to add value " But the asset mix between the classes is often not managed K Changing the asset mix through the specialized managers can be long and expensive " Derivatives offer a cheap and quick way to change the asset mix Page 9
GLOBAL ASSET MIX OVERLAY Pension Plan Asset Mix Overlay Manager Currency Overlay Manager Manager A Manager B Manager C Manager D Canadian Equities US Equities International Equities Canadian Fixed Income Cash Page 10
GLOBAL ASSET MIX OVERLAY PORTFOLIO SIZE $ 100 MILLION ASSET MIX STRATEGY Overweight 10% Canadian Equities (S/P / TSE) Underweight 10% Canadian Bonds (SMUI) STOCK FUTURES in Nominal Value $ 10 000 000 # contracts = Index Price * Multiplier = 367.50 * $200 = 136 contracts Page 11
GLOBAL ASSET MIX OVERLAY BOND FUTURES Hedge Ratio ( H.R.) = BPV sm * Beta ctd * C.F. BPV - ctd H.R.. C.F. = 1.00. CTD beta =.84109. PV01 CTD =.07257. PV01 SMUI =.06872.06872 *.84109 * 1 = =.07257.796469 # contracts = in Nominal Value SMPI * 1000 * H.R. $ 10 000 000 = 118.69 * 1000 *.79649 = 106 contracts RESULT To implement the strategy, we would buy 136 SP/ TSE 60 futures contracts c and simultaneously sell 106 CGB futures contracts Page 12
GLOBAL ASSET MIX OVERLAY 50% 40% 30% 20% 10% 0% -10% Asset Classes Exposure Benchmark weight Overlay strategy Effective result -20% Cash CAD Bonds CAD Equities USD Equities INTL Equities 80% Currency Exposure 60% 40% 20% 0% -20% -40% CAD USD JPY EUR GBP Page 13
TRADITIONAL BOND PORTFOLIO MANAGEMENT Page 14
BOND PORTFOLIO THE SOURCES OF ADDED VALUE IN OUR GLOBAL BOND PORTFOLIO COME FROM : 1) Country Selection 2) Asset Class Selection ( Sovereign, MBS s, Corporates ) 3) Duration / Yield Curve Positioning 4) Issue Selection 5) Currency Management Page 15
BOND PORTFOLIO THE PORTFOLIO CONSTRAINTS (RELATED TO DERIVATIVES) USUALLY ARE : No Leverage ( most funds) Limited Exposure to Synthetic Position ( usually 40%) Fixed Income Derivatives are used in 2 of our added-value sources Page 16
BOND PORTFOLIO USES OF BOND FUTURES IN OUR GLOBAL BOND PORTFOLIO K SYNTHETIC EXPOSURE - Our international portfolios cover several countries - Futures allow us to gain exposure to most sovereign segments - Futures allow us to go over the 30% foreign limit - Futures allow us to modify our country selection in a low-cost/efficient manner Page 17
BOND PORTFOLIO USES OF BOND FUTURES IN OUR GLOBAL BOND PORTFOLIO (cont d)( K DURATION MODIFICATION Futures allow us to tactically alter the duration of our portfolios K CURVE POSITIONING The availability of different contract maturity dates (US 2,5,10, 30 years and Germany 2, 5, 10 years) allow us to effectively and tactically manage the yield curve positioning of our portfolios. Page 18
BOND PORTFOLIO FIXED INCOME SYNTHETIC EXPOSURE K K K Cash invested in Money Market Futures are bought to gain exposure to the desired market This portion of the portfolio is considered as Canadian content Page 19
BOND PORTFOLIO Assume we want to increase the U.S. exposure and decrease the Euro exposure of our portfolio (sovereign) by 5% Portfolio size is $100 million with a duration of 5.5 and a yield of 4.06 The U.S. portfolio by $ 5 million Find BPV or additional bonds : Portfolio duration * $5 000 000 *.0001 (1+ Port Yield ) 2 Find the number of contracts to buy: BPV of additional bonds to acquire BPV of Bond Futures Page 20
BOND PORTFOLIO In this case, BPV of additional bonds: 5.5 * $ 5 000 000 *.0001 = $ 2695.29 1 + 4.06 2 BPV of Futures = $ 66.70 Number of US Futures contracts to BUY $ 2695.29 $ 66.70 = 40 contracts Page 21
BOND PORTFOLIO DURATION : Assume the strategy calls for an increase of the U.S. duration in our portfolio Actual portfolio strategy 5.50 Target duration 6.00 Portfolio size $100 million $ Value of Futures (30yr) $ 115 512 $ Value of Futures (5yr) $ 115 615 Yield 4.06 Page 22
BOND PORTFOLIO By selling 5 yr Bond Futures and buying 30 yr Futures, the gain in duration is 7.75 year per contract. For the portfolio to gain.50 year in duration, approximately 7% of the portfolio must be traded ($7mm).07 * 7.75 =.54 gain in duration Page 23
BOND PORTFOLIO Where leverage is permitted, find the BPV of Bonds to acquire Duration - Target Duration * Portfolio size *.0001 (1 + Port Yield ) 2 5.5-6 * $ 100 million *.0001 = $ 4900 (1+ 4.06 ) 2 BPV of Bonds to acquire $4900 = 40 contracts BPV of Futures $122.90 Page 24
BOND PORTFOLIO CURVE POSITIONING: Assume our strategy calls for a change from a bullet portfolio to a more barbell portfolio. Using futures, we sell 10 yr futures to underweight this sector of the curve and simultaneously buy 5 yr and 30 yr bond futures to overweight these sectors. Page 25
BOND OVERLAY Page 26
Asian E. Managed Index Physical Index Synthetic BOND OVERLAY GLOBAL ASSET MIX Page 27 CURRENCY COUNTRY N. A. E. Euro E. GLOBAL BONDS MONEY MARKET Managed Index Physical Index Synthetic Managed Index Physical Index Synthetic Managed Index Physical HEDGE FUNDS
BOND OVERLAY " INVEST IN DERIVATIVE PRODUCTS ON INTEREST RATES AND CURRENCIES " PERFORMANCE TARGET : Add value by actively managing International Bond spreads and currencies over and above what the Cash portfolio earns over the benchmark. " GUIDELINES : Independent decision making process Duration neutral for the spread overlay Risk management Risk per transaction Systematic stop losses Page 28
BOND OVERLAY Global Bond Spreads Overlay Currency Overlay Your Portfolio Your Portfolio + Added Value Page 29
BOND OVERLAY " Trade example: flattening of the yield curve - 10-year rates are expected to outperform 2 year rates in the U.S. - No market exposure desired (flat duration ) Buy 100 TY contracts (PV01 =.0659*1.000 = 6590$) Sell 148 TU contracts (PV01 =.0222*148*2000= -6570$) " Trade example: narrowing of the spread between 2 countries Canadian 10-year rates are expected to outperform US 10-year rates No market exposure desired (again flat duration ) Buy 100 CGB contracts (PV01 =.0738*100*1.000 = 7380$) Sell 71 TY contracts (PV01 =.0659*71*1.000*1.584 = -7410$) Page 30
HURDLES TO THE USE OF DERIVATIVES " Perception of Derivatives as Risky - Leverage - Financial fiascos in recent years " Education Client and portfolio manager About characteristics of futures and options Proper understanding of the strategic use of derivatives " Laws and Regulations National instruments 81-102 Page 31
RISK MANAGEMENT CONTROLS " Market Risk - Leverage monitoring - Calibration of active risk with performance objective - Systematic stop loss " Operational Risk Separation of duties Priority to exchange traded contracts over OTC Due diligence for new contracts (liquidity, regulation ) " Credit Risk - Credit exposure must not exceed 10% - Counterparties must be AA-minimum Page 32