The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• Risk models describe the different imbalances of a portfolio using a common language. The imbalances are combined into a consistent and coherent analysis reported by the risk model.

• Risk models provide important insights regarding the different trade-offs existing in the portfolio. They provide guidance regarding how to balance them.

• Risk models in fixed income are unique in two different ways: First, the existence of good pricing models allows us to robustly calculate important analytics regarding the securities. These analytics can be used confidently as inputs into a risk model. Second, returns are not typically used directly to calibrate risk factors. Instead returns are first normalized into more invariant series (e.g. returns normalized by the duration of the bond).

• The fundamental systematic risk of all fixed income securities is interest rate and term structure risk. This is captured by factors representing risk-free rates and swap spreads of various maturities.

• Excess (of interest rates) systematic risk is captured by factors specific to each asset class. The most important components of such risk are credit risk and prepayment risk. Other risk factors that can be important are implied volatility, liquidity, inflation or tax policy.

• Idiosyncratic risk is diversified away in large portfolios and indexes but can become a very significant component of the total risk in small portfolios. The correlation of idiosyncratic risk of securities of the ...