Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 13. Fixed Income Risk Modeling

LUDOVIC BREGER, PhD

Principal, Barclays Global Investors

OREN CHEYETTE, PhD

Principal, Barclays Global Investors

Abstract: Most asset owners have traditionally viewed fixed income securities as a relatively safe asset class—a haven from volatility in equity and other markets. While it is certainly true that government bonds are generally a low-risk asset class for domestic investors in developed markets, long-term government bonds can be every bit as risky as a diversified equity portfolio. More generally, many fixed income securities, such as mortgage backed securities, collateralized debt obligations or high-yield bonds can be relatively risky investments: Driven by a variety of pressures, including requirements from asset owners and regulators, there is a continuing demand in the financial community for improved tools for quantitative risk forecasting of fixed income portfolios.

Keywords: risk analysis, interest rate risk, term structure risk, spread risk, emerging market spread factors, implied prepayment risk, implied volatilty risk, sprecific risk, currency risk, global model integration

Risk analysis is the art and science of forecasting portfolio return variability. It involves several components. One is the choice of the risk measure. Typical in the asset management community is use of the width of the expected return distribution, commonly the standard deviation. An alternative, widely used in the banking world, is a loss value measure ...