InterAmerican Development Bank

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Inter-American Development Bank
FINANCE DEPARTMENT
Treasury Risk Management and Middle Office Unit
Review of an Approach for Analyzing Latin
AmericanFixed Income Securities
LAC Debt Group Workshop
Washington, DC
October 26-27, 2006
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Agenda

• Background of the Project Study
• Factors Contributing to an Attractive Investment
  Climate in Latin America
• Historical Performance of Latin American Debt
  Investments
• A Modified Framework for Relative Value and Yield
  Curve Analysis
• Summary of Findings

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Background of the Project Study
PROJECT OBJECTIVES AND DELIVERABLES

• In June 2006, IDB Senior Management requested a
  study to review a framework for analyzing Latin
  American debt securities.
• The review had two objectives
• to evaluate models for relative value and
  portfolio analysis and determine their potential
  application to capital market and portfolio
  management operations of the Bank and,
• to apply these models in an analysis of the risks
  and returns of Latin American debt securities.
• Three analytical tools were developed to carry
  out the research study
• Portfolio Optimization Tool for efficient
  frontier analysis
• Yield Decomposition Model for relative value
  analysis and yield curve development
• Technical Model for facilitating Foreign Exchange
  (FX) forecasts

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Factors Contributing to an Attractive Investment
Climate in Latin America
STRONG ECONOMIC FUNDAMENTALS IN LATIN AMERICA

• A confluence of positive factors has led to an
  attractive investment climate in Latin America.
• Real GDP growth in the region is expected to
  continue at a robust 4 to 5, driven by high
  commodity prices, increased exports, and the
  global economic expansion.
• Current account surpluses and foreign direct
  investment have contributed to rising
  international reserves, supporting a
  strengthening of regional exchange rates versus
  the US dollar.
• Strong economic growth has been coupled with
  lower inflation, and a decline in interest rates.

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Factors Contributing to an Attractive Investment
Climate in Latin America
AN IMPROVED ENVIRONMENT FOR INVESTMENT

• Although the region may be vulnerable to a
  slowdown in world economic growth and lower
  commodity prices, recent policy reforms have
  improved the resilience of country economies.
• Many countries have reduced budget deficits and
  public debt relative to GDP, and have adopted
  flexible exchange rates to limit vulnerability to
  external events.
• Some countries such as Brazil, Chile, Colombia,
  Mexico, and Peru have introduced inflation
  targeting, reduced exposure to external debt, and
  increased debt issuance in local currencies.
• To further develop capital markets, measures such
  as lowering withholding taxes, eliminating
  capital controls, and issuing local currency debt
  with greater transparency, were adopted.
• Recent structural reforms, sound macroeconomic
  policies, and improved fiscal management, if
  sustained, provide a favorable environment for
  long-term growth and investment in the region.

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Historical Performance of Debt Investments in
Latin America
HIGH RETURNS AND VOLATILITY

• Despite high volatility from a series of
  financial and economic crises over the past 9
  years, average returns for Latin American debt
  had outpaced those of traditional asset classes.
• Strong fundamentals over the past 3 years had led
  to impressive gains in the bonds of individual
  countries, contributing to higher long-term
  average annualized returns.

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Historical Performance of Debt Investments in
Latin America
LOW CORRELATIONS

• Low correlations between Latin American bond
  indices and traditional asset classes highlight
  the potential diversification benefits of adding
  Latin bonds to a typical global investment
  portfolio.
• Latin American local currency versus
  USD-denominated debt also exhibited low
  correlations.

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Historical Performance of Debt Investments in
Latin America
HISTORICAL EFFICIENT FRONTIER ANALYSIS

• A series of portfolio optimization experiments
  were run using data from 06/1997-06/2006 to
  determine if the addition of Latin American bonds
  would have added value to various global
  investment portfolios.
• Five portfolios or funds were created and
  analyzed using the indices shown below.

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Historical Performance of Debt Investments in
Latin America
GLOBAL INVESTMENT FUND (GIF)

• If Latin bonds were added to the GIF and held
  over the past 9 years, higher returns per unit of
  risk would have been realized, and the GIF Base
  Efficient Frontier would have expanded
  moderately.
• Allocating just 1.5 to Latin bonds would have
  increased returns by 0.14, accompanied by a
  negligible increase in volatility of 0.02 the
  Sharpe Ratio would have increased from 0.38 to
  0.40.
• As more Latin bonds were added, returns increased
  more relative to risk, so that at the maximum
  risk portfolio with 23 Latin bonds, a 2.05
  increase in returns would have led to a 1.86
  increase in risk.

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Historical Performance of Debt Investments in
Latin America
GLOBAL FIXED INCOME FUND (GFIF)

• Including 15 Latin bonds to the GFIF over the
  past 9 years would have resulted in higher
  returns and lower risk, and a much improved
  efficient frontier.
• Returns would have increased by 0.69, and risk
  would have actually been lower by 0.34,
  resulting in a significant increase in the Sharpe
  Ratio from 0.52 to 0.70.
• The slope of the efficient frontier would have
  been steeper, and at the maximum risk portfolio
  (30 Latin bonds), a 2.43 increase in returns
  would have entailed only a 0.94 increase in
  volatility.

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Historical Performance of Debt Investments in
Latin America
US FIXED INCOME FUND (UFIF)

• The addition of Latin bonds to the UFIF over the
  past 9 years would have significantly expanded
  the UFIF Base Efficient Frontier, resulting in
  higher returns and lower risk at the minimum risk
  portfolio.
• Allocating 10 to Latin bonds would have
  increased returns by 0.23, and lowered risk by
  0.29, leading to an increase in the Sharpe Ratio
  from 0.69 to 0.84.
• Sharpe Ratios would have increased further
  through the frontier up to a peak of 0.95, and
  then declined to 0.90 at the maximum risk
  portfolio.

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Historical Performance of Debt Investments in
Latin America
GLOBAL EMERGING MARKET BOND FUND (GEMF)

• A GEMF with Latin bonds held over the past 9
  years would have had high returns with high
  volatilities, and would have only been
  appropriate for investors with high risk
  tolerances.
• The minimum risk portfolio, created by allocating
  65 emerging market bonds, would have been a high
  risk, high return portfolio with returns being
  higher by 3.23 but with risk also going up by
  4.04.
• Sharpe Ratios would have declined throughout the
  frontier, so that, at the maximum risk portfolio,
  5.76 higher returns would have come at a cost of
  8.83 volatility.

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Historical Performance of Debt Investments in
Latin America
LATIN AMERICAN EMERGING MARKET BOND FUND (LAEMF)

• A Latin bond fund operating over the past 9 years
  would have had a high risk, high return profile
  appropriate only for investors with high risk
  tolerances.
• Allocating 55 Latin bonds to the minimum risk
  portfolio would have increased returns by 2.83,
  while risk would have increased by 2.41 versus
  the LAEMF Base portfolio.
• Sharpe Ratios would have declined throughout the
  frontier, although their relatively high levels
  show that the performance of the LAEMF would have
  surpassed that of the GEMF on a risk-adjusted
  basis.

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Historical Performance of Debt Investments in
Latin America
IF 20/20 HINDSIGHT LOOKED GOOD, HOW WOULD ONE
PROCEED?

• Cautiously. Our review of the historical
  performance of Latin American debt investments
  only provides insights into what happened in the
  past, not what may happen in the future.
• Professional investors typically complement what
  they have studied about the past with what they
  are assuming about the future, through the use of
  predictive models.
• Key players in emerging markets develop
  forward-looking models and invest in an
  infrastructure of dedicated personnel, models,
  and systems due to potential gains from their
  use.
• Typically, macro-level input is taken from teams
  of chief investment officers, portfolio
  strategists, and economists, and combined with
  micro-level input from analysts and traders.
• For instance, models to forecast expected returns
  could take into account that credit spreads have
  tightened considerably to historically low
  levels, so further capital gains may be limited.
• The impact of structural changes in the
  macro-economic environment and how these may
  affect assumptions on volatilities and
  correlations may also be considered.

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Local Currency Yield Decomposition Framework
YIELD DECOMPOSITION FRAMEWORK

• Deutsche Bank (DB) gave us a glimpse of some of
  the sophisticated relative value methodologies
  and tools that they use for emerging market
  research, including a methodology for decomposing
  local yields.
• We then developed a modified framework for
  analyzing local currency yields, which includes
  our own Technical Model for FX forecasting, and
  two models which apply DBs methodologies.
• The US Treasury Yield, US Libor Swap Spread, and
  USD External Sovereign Debt Spread are derived
  from the market.

Yield Decomposition Framework for Offshore Local
Bond and Swap Yields
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Local Currency Yield Decomposition Framework
USES OF THE YIELD DECOMPOSITION FRAMEWORK

• Relative Value Analysis - A Yield Decomposition
  Model (YDM) that brings together market as well
  as modeled components of yield could be used to
  analyze relative value in local currency debt
  instruments.
• Expected FX depreciation, the largest component
  of local yields, is modeled versus the market.
• Our Technical Model for expected FX depreciation
  translates forecasts from various sources into
  their views on real exchange rates, and shows how
  they compare with historical equilibrium levels.
• Yield Curve Development - A framework for
  analyzing yields would be one quantitative
  approach for creating or extending local currency
  yield curves in illiquid markets.
• Modeling of FX depreciation allows valuation of
  long-dated swaps, and facilitates extension of
  the curve.
• If the effect of Negative Sovereign Credit
  Correction is properly modeled, an offshore
  government curve can be derived from the offshore
  swap curve.
• The negative sovereign credit spread adjustment
  accounts for lower loss given default for
  positive correlations between the sovereign
  credit spread and FX rates.

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Local Currency Yield Decomposition Framework
EXCHANGE RATE PROCESS

• The exchange rate process is modeled via the real
  exchange rate (RER).
• RER scenarios are converted into nominal FX
  scenarios by incorporating inflation projections
  (i.e, from inflation-linked bonds).
• The following equations define the relationships
  between RER, nominal FX, and inflation

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Local Currency Yield Decomposition Framework
IDB MODEL OF REAL EXCHANGE RATE DYNAMICS

• We modeled the dynamics of the RER process,
  capturing the stationary, cyclical nature of RER
  movements, and the effect of its long-term
  equilibrium, through the following mean-reverting
  process

where X cumulative Log(RER) from a base date of
January 1999, X8 is the long-term equilibrium
RER, b the speed of mean reversion, Zt is a
deterministic function for short-term effects,
and s volatility in RER returns.

• After a few transformations, the solution comes
  to

• The solution to the RER stochastic differential
  equation allows X to be derived analytically. The
  models parameters are calibrated to an RER
  forecast, which in turn is derived from a given
  FX forecast.

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Local Currency Yield Decomposition Framework
RELATIVE VALUE ANALYSIS

• The following example compares BRL/USD FX
  forecasts from the market (NDFs) versus
  Commerzbank.

• Less expected depreciation from Commerzbank
  implies 236 to 580 bps of relative value.
• Our RER model translates Commerzbanks forecast
  into an expected change in RERs from the current
  base level of -0.25, to short term and long-term
  equilibrium RERs of -0.32 and -0.02,
  respectively.
• The NDF market projects short-term and long-term
  equilibrium RERs to be -0.08 and 0.08,
  respectively.

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Local Currency Yield Decomposition Framework
EXAMPLE OF SWAP CURVE EXTENSION

• To model an extension of the BRL Swap Curve
  beyond the 5-year point, we begin by projecting
  RER to its long-term equilibrium point of 0.08
  implied by the market.
• The implied FX yield component is derived from
  RERs and market inflation differentials as shown
  below.

• Market risk premium is the other yield component
  that has to be modeled beyond the 5-year point,
  and we applied DBs methodology to calculate this
  premium and obtain the full swap curve.

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Local Currency Yield Decomposition Framework
EXAMPLE OF OFFSHORE GOVERNMENT CURVE

• To build an offshore government bond curve for
  Brazil, we first derive its market yield
  components a) US Treasuries and b) external debt
  spreads from credit default swaps.
• Expected FX depreciation is derived as explained
  in the previous example for the offshore swap
  curve.
• Market risk premium is implied from the other
  components, and derived from the 10-year point,
  which was the market yield on 6/30/06.
• The negative sovereign credit spread adjustment
  is modeled using DBs methodology.

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Local Currency Yield Decomposition Framework
SCENARIO ANALYSIS

• Running various scenarios could provide clues on
  what may be the sources of discrepancies in
  pricing between the offshore swap market and
  offshore government bond market (i.e., liquidity
  conditions, supply/demand).
• It may be worthwhile studying changes in yield
  component differentials between the two markets
  over time.

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Summary of Key Findings
FINDINGS ON THE RESEARCH STUDY

• After a comprehensive analysis, we may conclude
  that Latin American debt securities warrant
  further study as a potential value-adding asset
  class in global investment portfolios.
• Strong economic fundamentals, continued
  structural reforms and sound monetary and fiscal
  policies in Latin America have created a
  favorable climate for investment.
• Although considered a high risk, high return
  asset, low correlations of Latin bonds with
  traditional asset classes provide diversification
  benefits that may improve the risk-return profile
  of portfolios.
• We have demonstrated that, had Latin American
  bonds been part of portfolios with various
  investment strategies over the past 9 years, the
  portfolio efficient frontiers would have
  improved.
• These results are based on historical data and
  only provide insights into the value potential of
  Latin bonds. Forward-looking relative value
  models will be required to complement the
  analysis.

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Summary of Key Findings
FINDINGS ON THE REVIEW OF METHODOLOGIES AND MODELS

• Regarding our review of relative value and
  portfolio methodologies and models, we have
  identified a number of applications that are
  within the scope of current operations.
• The Portfolio Optimization Tool has its obvious
  uses in analyses required for establishing
  treasury risk policies, and for the prudent
  management of risk in the Banks investment
  portfolio.
• The YDM and the Technical FX forecasting models
  could be applied in marking-to-model local
  currency financing structures with illiquid or
  incomplete market yield curves.
• These models will also be used in developing a
  methodology for managing model risk in illiquid
  markets, and in enhancing the Derivative Credit
  Risk Management (DCRM) system.
• Beyond these applications, state-of-the-art
  relative value and portfolio models could support
  an initiative to develop Latin American capital
  markets through a Fund similar to the Asian Bond
  Fund.
• The launch of a similar initiative for Latin
  America would require best practice emerging
  market research and investment management
  functions.

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provided solely for general informational
purposes and may or may not, at the time of its
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the IADB disclaims any and all liability relating
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contains or makes reference to various dates, but
makes no representation for subsequent events.
Past performance is not necessarily indicative of
future results.