Vineer Bhansali
Managing Director, Portfolio Manager
PIMCO
Q-Group Presentation
October 2015
!mk_Risk_Management
pg 0
This material is for presentation to Q-Group. It is for educational purposes only and should not be considered as investment advice or a
recommendation of any particular security, strategy or investment product. The references to "insurance" contained herein do not refer
to traditional insurance related products , but rather portfolio management techniques employed for insurance like characteristics.
PIMCO does not offer insurance guaranteed products or products that offer investments containing both securities and insurance
features. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and
concerns. Investors should consult their investment professional prior to making an investment decision. Information contained herein
has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or
referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are
trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC,
respectively, in the United States and throughout the world. Pacific Investment Management Company LLC, 650 Newport Center Drive,
Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO
Past performance is not a guarantee or reliable indicator of future results.
No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to
those shown. Hypothetical and forecasted performance results have several inherent limitations. Unlike an actual performance record,
these results do not do not reflect actual trading, liquidity constraints, fees, and/or other costs. There are numerous other factors related
to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the
preparation of simulated or forecasted results and all of which can adversely affect actual results. In addition, references to future results
should not be construed as an estimate or promise of results that a client portfolio may achieve.
pg 1
“A basic principle of Austrian economics is that the
original rate of interest (the rate of discount of future
goods compared to the present, otherwise identical,
goods) can never be negative. The reason for this arises
not because capital is productive, nor out of man’s
psychology. Rather, it is embedded in the very concept
of human action.” Walter Block [1978].
“it may be time […] to go negative”, If lowering interest
rates stimulates the economy and policy rates are
already very low or even zero, then why not keep
cutting rates and have negative interest rates? The idea
of negative rates, that is, lending 100 and getting back
say 95, may seem absurd “but remember this: Early
mathematicians thought the idea of a negative number
was absurd [too]“. Benoit Coeure quoting Greg
Mankiw [2014].
pg 2
% of Global Govt Index at negative yield
50%
45%
CHF
EUR
SEK
DKK
JPY
40%
35%
30%
25%
20%
15%
10%
5%
0%
27-Jan-14
27-Apr-14
27-Jul-14
27-Oct-14
27-Jan-15
As of February 2015
SOURCE: J.P. Morgan
pg 3
 Explanations for negative bond yields
 Negative yields as insurance
– The insured discount factor
– Impact of Risk aversion vs. subjective probabilities
 Implications for Asset pricing, Risk Premia, and Diversification with negative
yields
 A simplified framework
pg 4
 Technical reason 1: Supply-demand imbalance
– Sovereigns buying up all the float of existing bonds
 Technical reason 2: Indexation of bonds markets
– Preferred habitats of investors
 Economic reason 1: Demographics of aging populations and changing
preferences. Different consumption basket in older age that requires
deferred consumption
 Economic reason 2: Rare disaster and/or protracted deflation premium
pg 5
Net Issuance (inc. CB Purchases) (USD bn)
3,500
Japan
3,000
UK
2,500
Europe
2,000
US
1,500
TOTAL
1,000
500
1980
1985
1990
1995
2000
2005
2010
2015
-500
-1,000
As of February 2015
SOURCE: Morgan Stanley
pg 6
pg 7
 Peso problem: Mexican peso traded at long term discount for 20 years before
the devaluation happened
 Reverse peso problem: Swiss Franc trades at premium (and negative rates)
structurally – it’s a reverse peso problem or insurance against global financial
catastrophe
pg 8
“Imagine
that the Fed were to announce that, a year from today, it would pick a
digit from zero to 9 out of a hat. All currency with a serial number ending in that
digit would no longer be legal tender. Suddenly, the expected return from holding
currency would become negative 10 percent. That move would free the Fed to cut
interest rates below zero. People would be delighted to lend money at negative 3
percent, since losing 3 percent is better than losing 10 percent.”
– Mankiw, quoting an unnamed graduate student in the NY Times, April 18, 2009
pg 9
Tenors
3Mo
6Mo
1Yr
2Yr
3Yr
4Yr
5Yr
6Yr
7Yr
8Yr
9Yr
10Yr
12Yr
15Yr
20Yr
25Yr
30Yr
50Yr
Zero
10/20/20
15
3MO
6MO
1YR
-0.72
-0.72
-0.61
-0.77
-0.67
-0.67
-0.69
-0.81
-0.74
-0.75
-0.76
-0.82
-0.81
-0.81
-0.83
-0.87
-0.85
-0.85
-0.85
-0.87
-0.83
-0.83
-0.81
-0.80
-0.74
-0.74
-0.71
-0.68
-0.62
-0.62
-0.58
-0.55
-0.50
-0.50
-0.47
-0.43
-0.40
-0.40
-0.36
-0.33
-0.30
-0.30
-0.26
-0.23
-0.20
-0.20
-0.17
-0.14
-0.08
-0.07
0.12
0.12
0.14
0.17
0.45
0.43
0.45
0.47
0.59
0.56
0.73
0.69
0.70
0.71
0.73
0.70
2YR
3YR
4YR
5YR
10YR
15YR
30YR
-0.82
-0.84
-0.87
-0.90
-0.86
-0.74
-0.60
-0.46
-0.35
-0.24
-0.14
-0.08
-0.90
-0.92
-0.94
-0.85
-0.70
-0.53
-0.38
-0.27
-0.16
-0.05
0.01
0.07
-0.78
-0.78
-0.77
-0.58
-0.39
-0.24
-0.13
-0.03
0.08
0.13
0.18
0.24
-0.45
-0.43
-0.39
-0.21
-0.07
0.02
0.12
0.22
0.26
0.30
0.35
0.40
-0.12
-0.09
-0.03
0.09
0.16
0.25
0.34
0.36
0.40
0.44
0.49
0.54
0.45
0.46
0.50
0.56
0.63
0.69
0.76
0.82
0.89
0.95
1.02
1.09
1.11
1.13
1.16
1.23
1.30
1.37
1.44
1.37
1.33
1.31
1.30
1.30
0.73
0.73
0.73
0.73
0.73
0.73
0.73
0.73
0.73
0.73
0.73
0.73
0.24
0.51
0.38
0.61
0.53
0.72
0.69
0.82
0.83
0.90
1.11
1.18
1.34
1.21
0.73
0.73
0.74
0.80
0.86
0.92
0.96
1.05
1.06
0.73
pg 10
Tenors
3Mo
6Mo
1Yr
2Yr
3Yr
4Yr
5Yr
6Yr
7Yr
8Yr
9Yr
10Yr
12Yr
15Yr
20Yr
25Yr
30Yr
50Yr
10/20/20
15
3MO
6MO
1YR
2YR
3YR
4YR
5YR
-0.642
-0.776
-0.736
-0.777
-0.591
-0.342
-0.021
-0.666
-0.678
-0.698
-0.714
-0.688
-0.521
-0.273
0.046
-0.684
-0.695
-0.716
-0.700
-0.667
-0.489
-0.223
0.110
-0.681
-0.680
-0.669
-0.642
-0.578
-0.356
-0.057
0.279
-0.617
-0.615
-0.589
-0.550
-0.459
-0.200
0.111
0.422
-0.518
-0.515
-0.477
-0.428
-0.315
-0.038
0.260
0.532
-0.392
-0.389
-0.343
-0.287
-0.163
0.110
0.380
0.619
-0.252
-0.249
-0.200
-0.142
-0.019
0.235
0.477
0.690
-0.115
-0.113
-0.065
-0.010
0.106
0.338
0.557
0.743
0.006
0.008
0.053
0.104
0.212
0.425
0.620
0.800
0.111
0.114
0.156
0.203
0.304
0.495
0.683
0.837
0.203
0.205
0.244
0.287
0.378
0.564
0.728
0.876
0.354
0.356
0.390
0.428
0.506
0.664
0.818
0.938
0.523
0.525
0.553
0.584
0.649
0.778
0.901
1.011
0.708
0.709
0.732
0.756
0.807
0.907
1.001
1.084
0.817
0.818
0.835
0.854
0.893
0.970
1.042
1.103
0.864
0.865
0.877
0.891
0.920
0.976
1.027
1.068
0.820
0.828
0.837
0.855
0.890
0.921
0.946
Cpn
10YR
15YR
30YR
0.316
1.021
1.170
0.792
0.377
1.029
1.168
0.784
0.449
1.072
1.192
0.786
0.579
1.144
1.229
0.783
0.674
1.144
1.262
0.781
0.748
1.169
1.294
0.777
0.809
1.204
1.325
0.774
0.851
1.202
1.313
0.771
0.902
1.211
1.309
0.769
0.931
1.225
1.311
0.766
0.965
1.243
1.316
0.763
1.001
1.263
1.323
0.760
1.037
1.264
1.292
0.755
1.103
1.281
1.268
0.747
1.152
1.250
1.154
0.734
1.151
1.166
1.080
0.722
1.097
1.104
1.027
0.711
0.963
0.957
0.897
0.672
pg 11
pg 12
pg 13
pg 14
pg 15
pg 16
’
pg 17
pg 18
pg 19
 Recent research (Welch 2015) suggests that index option prices can be used
to explain about 2% of the 7% equity risk premium as disaster
compensation
 Fitting a behavioral model (Bhansali 2015) suggests that the crisis of 2008
was different in attributing a much higher subjective probability to fat tails.
Compare this to 1987 where index option skew emerged mostly from
increased risk aversion
pg 20
Prices are expectations of risk adjusted discounted payoffs
Excess Returns are compensation for being short “insurance”
pg 21
n
n
i 1
i 1
ErP (t )  P (t )   Corr Pi(t ), Fi (t )Pi (t )Fi (t )   EPi(t )EFi (t )
Absolute Return
from “Skill”
Cyclical Timing
Secular/Structural
Positions
Performance can be decomposed into factor risk premium buy and hold, risk-premium timing, and alpha
See also A. Lo, The Active-Passive Decomposition
Lo, Andrew W. (2007), “Where Do Alphas Come From?”: A New Measure of the Value of Active Investment Management”, http://ssrn.com/abstract=985127
pg 22
 Credit: Default risk premium
 Equity: Growth risk premium
 Duration: Cash rebalancing premium
 FX Carry: Growth, inflation differential, volatility premium
 Commodity: Hedging pressures premium
 Etc.
pg 23
2.5
Term premium (%)
2
1.5
Term premium bunds
1
Term premium JGBs
Term premium UST
0.5
0
-0.5
-1
As of 27 March 2015
SOURCE: Bloomberg
mk_3cs_euro_outlook_04
Copied from Capital_Securities_Review_14 and
Capital_Securities_Strat_18
pg 24
pg 25
Source: Bloomberg
pg 26
 If yields are floored close to zero, the diversification properties of duration
are less potent
 When yields are very high, any further rise in yields usually means slowdown
in economic activity and downward bias to equities, all else being equal. So
this implies positive correlation to stocks and bonds returns
 When yields are very low for the same reason (i.e. higher yields would mean
lower growth), the same logic applies, and we may also expect correlations
becoming more positive
pg 27
 Are assets ex-ante insurance assets or investment assets?
– For insurance assets, depending on the moneyness of the insurance, risk premium
is paid, not earned.
– For investment assets, risk premium is earned as compensation for providing
insurance.
pg 28
Choosing individual stocks assets without any
idea of what you are looking for is like running
through a dynamite factory with a burning
match. You may live, but you’re still an idiot.
Paraphrasing Joel Greenblatt, author of The
Little Book that (still) beats the market.
pg 29
 Investors need to evaluate the mix of insurance assets and
investment assets in their portfolio according to their own
exposure and tolerance to disasters.
 The control of disaster risk allocation will then determine the
expected return.
pg 30
 Carry: Selling “insurance” against rare disasters
 Trend: Purchasing insurance against rare disasters
 Optimal mix of long and short implicit and explicit insurance based on
relative valuation
pg 31
Carry = Short Straddle
(selling insurance)
(Implieds)
Trend = Long Strangle
(buying insurance)
(Lookback, Realized)
pg 32
pg 33
pg 34
Indicator:
Assume unit long
position. Then,
If Trend and Carry
positive, then +1. If
they disagree, 0.
If Both negative,
then -1.
Average over each
sector.
Source: Bloomberg, PIMCO
pg 35
Be Long Markets
Be Short Markets
Source: Bloomberg, PIMCO
pg 36
COMM
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
FX
RATES
AVERAGE
0.33
-0.01
0.50
-0.03
1.00
0.70
-1.00
-1.00
0.58
0.29
-0.76
-0.21
2.66
2.98
-0.23
-0.20
1.00
-1.00
0.47
0.40
3.21
-0.14
0.00
1.00
-1.00
0.57
0.02
2.41
-0.01
0.00
1.00
-1.00
0.47
-0.07
2.03
302.67
0.00
154.39
0.00
426.50
0.00
1058.11
0.00
76.15
0.00
-2466.58
-1450.60
-150.00
3505.52
-140.42
Sum Sq. Dev.
2307.15
3483.25
2321.13
3559.69
879.22
Observations
10590.00
10590.00
10590.00
10590.00
10590.00
Jarque-Bera
Probability
Sum
Rank Correlations
EQTY
COMM
EQTY
FX
RATES
AVERAGE
COMM EQTY
1.00
0.05
0.23
-0.11
0.41
FX
0.05
1.00
0.04
0.17
0.60
RATES
AVERAGE
0.23
-0.11
0.41
0.04
0.17
0.60
1.00
0.09
0.56
0.09
1.00
0.57
0.56
0.57
1.00
Source: Bloomberg, PIMCO
pg 37
pg 38
pg 39

Chart shows cumulative excess returns of hypothetical monthly sales of 1M 40-delta “real-yield payer swaptions”, versus risk
parity excess returns.

Similar return profile, 69% monthly returns correlation.

Helps characterize the risk for which this strategy earns a premium.
Implied volatility estimated as 24 month exponential weighted realized volatility multiply by 1.04, the approximate average 1M 10Y IR Swap volatility skew implied vol premium observed since 1994.
Source: Bloomberg, PIMCO
Hypothetical example for illustrative purposes only.
pg 40
 Negative nominal (and real) yields are a reality and might reflect changes in
the economics of asset markets
 They highlight the dual nature of assets: as insurance assets (return of your
money), or investment assets (return on your money), under rare disasters
 Portfolio construction is less about maximizing expected return per unit of
risk, and more about the appropriate mix of sales and purchases of rare
disaster insurance
pg 41