Part III: A Helicopter View of Managing Bond Portfolio Risk
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1 Investments Analysis Lecture 8: Risk Management Primer Risks Market Risk Credit Risk Liquidity Risk Operational Risk, Legal Risk, Reputational Risk Focus: Bond portfolios» Not equity funds» Not banks Still, some common techniques Part III: A Helicopter View of Managing Bond Portfolio Risk Types of Risks Portfolio managers face various risks: Market Risk Credit Risk Liquidity Risk Other risks Operational Risk Legal Risk ReputationalRisk
2 Market Risk Definition Changes in asset prices affect portfolio value Example: Basis risk Changes in the difference between the values of assets/positions and the values of the instruments used as a hedges E.g., T-bills and commercial paper, Summer 2007 relative to a benchmark Bonds: BIG, AGG, etc. Equity Risk Market Risk 2 Interest-rate Risk: The one that matters for bonds Trading Risk General market risk + Specific risks Gap risk Differences in bond characteristics > changes in portfolio value E.g., yield curve shifts Currency Risk Commodity Risk Market Risk 3 Partial picture: Greeks Overall picture: Value At Risk (VAR)
3 Market Risk 4 Partial picture: Greeks Idea: Assess the sensitivity of a position s value (often, a derivative) to changes in a specific variable Overall picture: Value At Risk (VAR) Idea: Provide a comprehensive measure of market risk for individual securities and portfolios. Market Risk 5 Partial picture : Greeks Delta: Sensitivity to underlying asset s price Gamma: Sensitivity of delta to underlying asset s price» Helps determine frequency of rebalancing» Corrects for derivatives curvature Vega: Sensitivity to volatility Theta: Rho: Value change as time passes Sensitivity to risk-free rates Market Risk 6 Partial picture: Greeks Idea: Assess the sensitivity of the position s value to changes in a specific variable Problem 1: Greeks are not additive Sensitivities across markets cannot be added/averaged Sensitivities to relevant variables cannot be added/averaged Problem 2: Can t be used to assess # of capital at risk
4 Market Risk 7 Overall picture : Value At Risk (VAR) Definition: = what is the worst loss I can expect over a given time period, with a given level of probability?» Example: with 99% probability, we won t lose mose than $2bn in the next 20 days what is the most I can lose during a given time period?» answer to that = Everything! Market Risk 8 Overall picture: Value At Risk (VAR) Implementation: Step 1: Find a forward distribution of portfolio returns Approaches:» Historical» Assumptions (normal or fat-tailed distribution?)» Monte Carlo simulations Step 2: Identify percentiles» Basel I (banks): 99 th percentile over a 10-day window Market Risk 9 Overall picture: Value At Risk (VAR) Stress testing: Basel I example: Parallel Shifts (yield curve): +/-1% Twists (yield curve): +/- 0.25% Equity index: +/- 10% Currency changes: +/- 6% Volatility changes: +/- 20%
5 Market Risk 10: Bond Portfolios Duration and convexity VAR and stress tests Management Derivatives immunization Liquidity Risk Definition Funding risk Changes in the ability to raise cash for» Roll over debt» Meet margin/collateral requirements» Meet withdrawal requests by investors Trading-related risk: No one wants to trade Liquidity Risk 2 Very hard to quantify» Ask managers of ABS and SIV funds this Summer! Examples of estimates needed: Length of time for position liquidation (VAR) Once in a lifetime events» When Genius Failed (1997)» Black Swans (2007)
6 Definition Credit Risk Changes in issuer(s) credit quality > changes in portfolio value Intensity: Extreme: Default Importance Less extreme: Credit downgrades Positions in assets: Positions in derivatives: Can be very large Smaller (why?) Credit Risk 2 is difficult Traditional approach: Individual securities Modern Approach: Portfolio level Credit VAR» JP Morgan CreditMetrics > RiskMetrics» Idea: Credit migration KMV» Idea: Use equity information to assess equity default frequency Credit Risk 3 Traditional approach: Types External assessment:» Credit ratings Internal assessments» Ratio monitoring» Qualitative adjustment Individual securities
7 Credit Risk 4 Modern Approach: Issues Portfolio level» Credit risk of individual securities» Concentration risk Across assets and Across time (refi risk for managers)» State of the economy Methods» Credit VAR vs. KMV Modern Approach #1: Credit Risk 5 Credit migration approach Steps: Credit VAR» Assess the probability of shift across credit risk categories, and value the portfolio» Define bins» Specify the horizon to measure the risk» Forward discount curve» Forward distribution of changes in portfolio value» Now ready for VAR Problem: correlations Modern Approach #2: Credit Risk 6 Use the market approach Steps:» Use information in prices KMV» Estimate market value of firm and asset volatility as revealed in stock markets» Calculate distance to default» Scale distance to default to actual probabilities, using default database Problem: correlations
8 Management Credit Risk 7 Credit derivatives, anyone? Operational Risk Other Risks Exposure to losses due to» Inadequate technology» Indadequate systems or controls» Incompetent or fraudulent behavior by people Legal Risk Reputational Risk Partly linked to credit and liquidity risks
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