Additional risks in fixed-income markets

Over the past ten years, risk management and valuation techniques in fixed-income
markets have evolved from the use of static, somewhat naı¨ve concepts such as
Macaulay’s duration and nominal spreads to option-adjusted values such as effective
duration, effective convexity, partial or ‘key rate’ durations and option-adjusted
spreads (OAS). This reflects both the increased familiarity with these more sophisticated
measures and the now widespread availability of the analytical tools required
to compute them, including option models and Monte Carlo analyses for securities
with path-dependent options (such as mortgage-backed securities with embedded
prepayment options).
However, although these option-adjusted measures are more robust, they focus
exclusively on a security’s or portfolio’s interest rate sensitivity. While an adverse
change in interest rates is the dominant risk factor in this market, there are other
sources of risk which can have a material impact on the value of fixed-income
securities. Those securities that offer a premium above risk-free Treasury rates do
so as compensation either for some type of credit risk (i.e. that the issuer will be
downgraded or actually default), or ‘model risk’ (i.e. the risk that valuations may vary
because future cash flows change in ways that models cannot predict). We have seen
that gains from a favorable interest rate move can be more than offset by a change
in credit spreads and revised prepayment estimates can significantly alter previous
estimates of a mortgage portfolio’s interest rate sensitivity. The presence of these
additional risks highlights the need for measures that explain and quantify a bond’s
or portfolio’s sensitivity to changes in these variables.
This chapter discusses two such measures: spread duration and prepayment
uncertainty. We describe how these measures may be computed, provide some historical
perspective on changes in these risk factors, and compare spread duration and
prepayment uncertainty to interest rate risk measures for different security types. A
risk manager can use these measures to evaluate the firm’s exposure to changes in
credit spreads and uncertainty associated with prepayments in the mortgage-backed
securities market. Since spread duration and prepayment uncertainty may be calculated
both for individual securities and at the portfolio level, they may be used to
establish limits with respect to both individual positions and the firm’s overall exposure to these important sources of risk. Both measures are summarized below: