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

Chapter 17. Improving Guidelines for Interest Rate and Credit Derivatives

STEVEN K. KREIDER, PhD

Managing Director, Morgan Stanley Investment Management

SCOTT F. RICHARD, PhD

Managing Director, Morgan Stanley Investment Management

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: Portfolio managers will seek to control the interest rate risk and credit risk of a portfolio using the most effective means possible. By effective, we mean that changes in the risk exposure of a portfolio can be done quickly and at minimal transaction costs (where transaction costs include market impact costs). Typically, altering the risk exposure can be done most effectively using derivative instruments—futures, forwards, swaps, and options. While clients may have a general understanding of how a particular derivative instrument can impact the risk exposure of a portfolio to changes in interest rates, that is not enough. Risk control requires that this be quantified.

Keywords: investment guidelines, interest rate risk, notional value, futures, forwards, swaps, options, duration, dollar duration, leverage, credit default swaps (CDSs), loans

For managers to use derivatives effectively, client authorization must be clearly set forth in the investment guidelines. In this chapter we recommend how those guidelines that govern the use of futures contracts in a bond portfolio should be specified. We analyze the effects of guidelines that limit the face (or notional) ...