Encyclopedia of Financial Models I

Managing Credit Spread Risk Using Duration Times Spread (DTS)

ARIK BEN DOR, PhD

Managing Director, Barclays

LEV DYNKIN, PhD

Managing Director, Barclays

JAY HYMAN, PhD

Managing Director, Barclays, Tel Aviv

Abstract: Extensive empirical research has shown that the spread volatility of credit securities is linearly proportional to their level of spread. This finding holds true across corporate and sovereign issuers, for both cash and credit default swaps. A superior measure of spread risk for credit securities is the product of spread duration and spread, a measure referred to as duration times spread (DTS). DTS measures the sensitivity of the price of a bond to relative changes in spread, which are much more stable through time and cross-sectionally than absolute spread volatilities. DTS allows for better risk projection, hedging, replication, and portfolio construction.

The traditional presentation of the asset allocation in a portfolio or a benchmark is in terms of percentage of market value. For fixed-income portfolios, it is widely recognized that this is not sufficient, as differences in durations can cause two portfolios with the same market weight allocations to have very different exposures to macro-level risks. Market practices have evolved to address this issue. A common approach to structuring a fixed-income portfolio or comparing it to a benchmark is to partition it into homogeneous market cells comprised of securities with similar characteristics. Many fixed-income ...