. 36
( 60 .)


Quantifying Allocating
risk risk

Managing risk

This chapter examines ways that financial risks can be quantified, the
means by which risk can be allocated within an asset class or portfolio, and
the ways risk can be managed effectively.


Generally speaking, “risk” in the financial markets essentially comes down
to a risk of adverse changes in price. What exactly is meant by the term
“adverse” varies by investor and strategy. An absolute return investor could
well have a higher tolerance for price variability than a relative return
investor. And for an investor who is short the market, a dramatic fall in prices
may not be seen as a risk event but as a boon to her portfolio. This chap-
ter does not attempt to pass judgment on what amount of risk is good or
bad; such a determination is a function of many things, many of which (like
risk appetite or level of understanding of complex strategies) are entirely
subject to particular contexts and individual competencies. Rather the text
highlights a few commonly applied risk management tools beginning with



products in the context of spot, then proceeding to options, forwards and
futures, and concluding with credit.


In the fixed income world, interest rate risk is generally quantified in terms
of duration and convexity. Table 5.1 provides total return calculations for
three Treasury securities. Using a three-month investment horizon, it is clear
that return profiles are markedly different across securities.
The 30-year Treasury STRIPS1 offers the greatest potential return if
yields fall. However, at the same time, the 30-year Treasury STRIPS could
well suffer a dramatic loss if yields rise. At the other end of the spectrum,
the six-month Treasury bill provides the lowest potential return if yields fall
yet offers the greatest amount of protection if yields rise. In an attempt to
quantify these different risk/return profiles, many fixed income investors
evaluate the duration of respective securities.
Duration is a measure of a fixed income security™s price sensitivity to a
given change in yield. The larger a security™s duration, the more sensitive that
security™s price will be to a change in yield. A desirable quality of duration
is that it serves to standardize yield sensitivities across all cash fixed income
securities. This can be of particular value when attempting to quantify dif-
ferences across varying maturity dates, coupon values, and yields. The dura-
tion of a three-month Treasury bill, for example, can be evaluated on an
apples-to-apples basis against a 30-year Treasury STRIPS or any other
Treasury security.
The following equations provide duration calculations for a variety of

STRIPS is an acronym for Separately Traded Registered Interest and Principal
Security. It is a bond that pays no coupon. Its only cash flow consists of what it
pays at maturity.

Risk Management

TABLE 5.1 Total Return Calculations for Three Treasury Securities
on a Bond-Equivalent Basis, 3-Month Horizon

Change in 7.75%
Yield Level Treasury Bill Treasury Note Treasury STRIPS
(basis points) (1 year) (%) (10 year) (%) (30 year) (%)

100 8.943 36.800 75.040
50 7.580 21.870 39.100
0 6.229 8.030 7.920
50 4.883 4.820 19.130
100 3.545 16.750 42.610

To calculate duration for a Treasury bill, we solve for:

P Tsm
P 365

where P Price
Tsm Time in days from settlement to maturity

The denominator of the second term is 365 because it is the market™s
convention to express duration on a bond-equivalent basis, and as presented
in Chapter 2, a bond-equivalent calculation assumes a 365-day year and
semiannual coupon payments.
To calculate duration for a Treasury STRIPS, we solve for:

Duration T
P sm

where Tsm Time from settlement to maturity in years.

It is a little more complex to calculate duration for a coupon security.
One popular method is to solve for the first derivative of the price/yield equa-
tion with respect to yield using a Taylor series expansion. We use a price/yield
equation as follows:

F C>2 F C>2 F11 C>22
11 11 11
Pd ...
Y>22 TSC>Tc Y>22 TSC>Tc TSC>TC
Y>22 N 1

where Pd Dirty price
F Face value (par)


C Coupon (annual %)
Y Bond-equivalent yield
Tsc Time in days from settlement to coupon payment
Tc Time in days from last coupon payment (or issue date) to next
coupon date

The solution for duration using calculus may be written as (dP™/dY)P™,
where P™ is dirty price. J. R. Hicks first proposed this method in 1939.
The price/yield equation can be greatly simplified with the Greek sym-
bol sigma, , which means summation. Rewriting the price/yield equation
using sigma, we have:


11 Y>22 t
t 1

where Pd Dirty price
T Total number of cash flows in the life of a security
Ct Cash flows over the life of a security (cash flows include
coupons up to maturity, and coupons plus principal at maturity)
Y Bond-equivalent yield
t Time in days security is owned from one coupon period to the
next divided by time in days from last coupon paid (or issue date)
to next coupon date

Moving along then, another way to calculate duration is to solve for

C't t

11 Y>22 t
t 1


11 Y>22 t
t 1

There is but a subtle difference between the formula for duration and the
price/yield formula. In particular, the numerator of the duration formula is
the same as the price/yield formula except that cash flows are a product of
time (t). The denominator of the duration formula is exactly the same as the
price/yield formula. Thus, it may be said that duration is a time-weighted
average value of cash flows.
Frederick Macaulay first proposed the calculation above. Macaulay™s
duration assumes continuous compounding while Treasury coupon securities

Risk Management

are generally compounded on an actual/actual (or discrete) basis. To adjust
Macaulay™s duration to allow for discrete compounding, we solve for:

11 Y>22

where Dmod Modified duration
Dmac Macaulay™s duration
Y Bond-equivalent yield

This measure of duration is known as modified duration and is gener-
ally what is used in the marketplace. Hicks™s method to calculate duration
is consistent with the properties of modified duration. This text uses modi-
fied duration.
Table 5.2 calculates duration for a five-year Treasury note using
Macaulay™s methodology. The modified duration of this 5-year security is
4.0503 years.
For Treasury bills and Treasury STRIPS, Macaulay™s duration is noth-
ing more than time in years from settlement to maturity dates. For coupon
securities, Macaulay™s duration is the product of cash flows and time divided
by cash flows where cash flows are in present value terms.
Using the equations and Treasury securities from above, we calculate
Macaulay duration values to be:

1-year Treasury bill, 0.9205
7.75% 10-year Treasury note, 7.032
30-year Treasury STRIPS, 29.925

Modified durations on the same three Treasury securities are:

Treasury bill, 0.8927
Treasury note, 6.761
Treasury STRIPS, 28.786

The summation of column (D) gives us the value for the numerator of
the duration formula, and the summation of column (C) gives us the value
for the denominator of the duration formula. Note that the summation of
column (C) is also the dirty price of this Treasury note.

Dmac 833.5384/98.9690 8.4222 in half years
8.4222/2 4.2111 in years



. 36
( 60 .)