Investment Risk and Uncertainty: Advanced Risk Awareness Techniques for the Intelligent Investor

CHAPTER 11

Fixed Income Interest Rate Volatility, Idiosyncratic Risk, and Currency Risk

David Mieczkowski, PhD, and Steven P. Greiner,PhD

FIXED INCOME INTEREST RATE RISK

Interest rates are just a way to express the time value of money in terms of holding period returns. Spot rates, which are the holding period returns of zero coupon bonds, also provide a term structure of holding period returns in terms of the length of the holding period. Interest rate risk is then concerned with the uncertainty or volatility of the holding period returns through time. If the spot curve were constant through time, there would be no interest rate risk. The spot curve needn’t be flat, since we could determine with full certainty the future value of any known cash flow over a horizon if we know what the term structure will be.

When thinking about interest rate volatility risk, we are led to ask two questions: Is interest rate volatility constant? For which securities does it even matter?

Let’s start with the second question. Consider a 10-year swap and a one-month investment horizon. Suppose we know the one-month volatility of the spot curve; then even if the volatility of the spot curve is itself volatile, it will not matter for determining the one-month risk. Over a particular horizon, once we know what the volatility of the spot curve is over that horizon, we do not care what future interest rate volatility will be. This might seem odd at first, but consider an overnight money market account. ...