Scenario modeling for the management of international bond portfolios

We address the problem of portfolio management in the international bond ma rkets. Interest rate risk in the local market, exchange rate volatility acr oss markets, and decisions for hedging currency risk are integral parts of this problem. The paper develops a stochastic programming optimization mode l for integrating these decisions in a common framework. Monte Carlo simula tion procedures, calibrated using historical observations of volatility and correlation data, generate jointly scenarios of interest and exchange rate s. The decision maker's risk tolerance is incorporated through a utility fu nction, and additional views on market outlook can also be incorporated in the form of user specified scenarios. The model prescribes optimal asset al location among the different markets and determines bond-picking decisions and appropriate hedging ratios. Therefore, several interrelated decisions a re cast in a common framework, while in the past these issues were addresse d separately. Empirical results illustrate the efficacy of the simulation m odels in capturing the uncertainties of the Salomon Brothers international bond market index.