Fixed Income Analysis, Second Edition

CHAPTER 17

MEASURING A PORTFOLIO’S RISK PROFILE

I. INTRODUCTION

Earlier, we described the risks associated with individual bonds. These risks include:

• Interest rate risk

• Call and prepayment risk

• Yield curve risk

• Reinvestment risk

• Credit risk

• Liquidity risk

• Exchange-rate risk

• Volatility risk

• Inflation or purchasing power risk

• Event risk

It is assumed that the reader is familiar with these risks.

Our focus is on bond portfolio strategies. In this chapter we explain how to measure a portfolio’s risk profile. Because we focus on bond portfolio strategies, our interest is on performance relative to a bond market index. We refer to the bond market index as the benchmark index. So the process of managing funds relative to a benchmark index requires that a manager thoroughly understand the portfolio’s risk profile relative to that of the benchmark index. The difference between the risk profile of the portfolio and the benchmark index results in performance differences. The best way to construct and control the risk profile of a portfolio relative to a benchmark index is to quantify all of the important risks. It is important to understand that a trade can reduce one type of risk while simultaneously increasing another.

II. REVIEW OF STANDARD DEVIATION AND DOWNSIDE RISK MEASURES

The risk associated with an investment can be defined in terms of a well-known statistical measure, the variance, or its conceptual equivalent, the standard deviation (the square root of the variance). ...