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price will not change dramatically within a short time after purchase.
However, as time from purchase date marches onward, the certainty of what
the price may do steadily declines. However, in the case of bonds, which have
known prices at maturity, the pull to par eventually becomes a dominant
factor and the probability related to price begins to increase (and reaches
100 percent at maturity for a Treasury security). The lower equity and cur-
rency profiles are consistent with the higher uncertainty (lower probability)
associated with these products relative to bonds. (The standard deviation of
price tends to be lowest for bonds, higher for equities, and higher again for


100% Bond


Maturity of
the bond

FIGURE 5.37 Probability profiles of a sample bond, equity, and currency.

As we have seen time and again, we do not need to venture very far in the world
of finance and investments to come face-to-face with a variety of risk consid-
erations. If all we care about is a safe investment with a six-month horizon,
then we can certainly go out and buy a six-month Treasury bill. There is no
credit risk, reinvestment risk, or price risk (as long as we hold the Treasury bill
to maturity). But what if we have a 12-month horizon? Do we then buy a 12-
month Treasury bill, or do we consider the purchase of two consecutive six-
month bills? What do we think of the price risk of a six-month Treasury bill
in six months? In sum, there is risk embedded in many of the most fundamental
of investment decisions, even if these risks are not explicitly recognized as such.
When investors purchase a 12-month Treasury bill, they are implicitly (if not
explicitly) stating a preference over the purchase of:

a. Two consecutive six-month Treasury bills
b. Four consecutive three-month Treasury bills
c. Two consecutive three-month Treasury bills, followed by the purchase
of a six-month Treasury bill
d. A six-month Treasury bill, followed by the purchase of two consecutive
three-month Treasury bills, or
e. A three-month Treasury bill, followed by the purchase of a six-month
Treasury bill, followed by the purchase of another three-month Treasury bill

Risk Management

Although the risks among these various scenarios may be minimal with
Treasury bills, the point here is to highlight how the decision to pursue strat-
egy option a necessarily means not pursuing strategy b (or c or d, etc.). There
are consequences for every investment decision that is taken as well as for
each one that is deferred.
In addition to the various risk classifications presented in this chapter,
there is also something called as event risk. Simply put, event risk may be
thought of as any sudden unanticipated shock to the marketplace. It is not
prudent for most portfolio managers to structure their entire portfolio
around an event that may or may not occur. However, it can be instructive
for portfolio managers to know what their total return profiles might look
like in the event of a market shock. Scenario analysis can assist with this.
Further, it also may be instructive for portfolio managers to know how prod-
ucts have behaved historically when subject to shocks. One way to concep-
tualize this would be with a charting of relevant variables as in Figure 5.38.
In sum, risk is elusive; that is why it is called risk. Simply dismissing it
is irresponsible. By thinking of creative ways in which to better understand,
classify, and manage risk, investors will be better equipped to handle the
vagaries of risk when they arise.

Total return

The intersection of
low event risk (0“3
standard deviations
of price risk), double-
A credit risk, and a
slightly positive total
0 return

1 to 3
3 to 6
6 to 9
Event risk
(Grouped by standard Credit risk
deviation [SD])

FIGURE 5.38 Another conceptual mapping of risk profiles.



Benchmark Risk
At first pass, having the words “benchmark” and “risk” together may seem
incongruous. After all, isn™t the role of a benchmark to provide some kind
of a neutral measure, some kind of pure yardstick by which to gauge rela-
tive market performance? While that certainly is the ideal role of a bench-
mark, with the dynamic nature of the marketplace generally, it often is an
ideal that is difficult to live up to.
For example, for decades U.S. Treasuries were seen as the appropriate
benchmark for divining relative value among bonds. In the late 1990s, with
the advent of unexpected and persistent federal budget surpluses, this sta-
tus began to look a little shaky. With Treasuries on a relative decline,
investors began to ask if there might be another benchmark security type
that could replace Treasuries as an arbiter of value. A particular financial
instrument does not become a benchmark by formal decree; it is much more
by what the market deems to be of relevance in a very practical way. That
is, the marketplace naturally gravitates toward obvious solutions that work
rather than pursue solutions that may be more theoretically pure though less
practical. Indeed, during the 1970s in the United States, longer-dated cor-
porate securities were used as market benchmarks, largely because they were
more prevalent at that time than the burgeoning federal budget deficits that
dominated the 1980s. In the late 1990s and into 2000, a debate was waged
as to whether federal agency debt might represent a more appropriate mar-
ket benchmark in light of the agencies™ net growth of issuance contrasting
against a net contraction in Treasuries. Indeed, the likes of Fannie Mae and
Freddie Mac introduced a regular cycle to key maturities in their debt man-
agement program to provide a market alternative to Treasuries. Over the
period of debate the federal agencies were greatly increasing their borrow-
ing programs relative to the U.S. government.
Another vehicle that sometimes is named as a benchmark possibility is
the swap yield. Proponents of this variable do not hold it up as a paragon
of market solutions, since it (like any one single variable that would be
selected) has its own strengths and weaknesses. As benchmark candidates,
swap yields have these points going for them (listed in no particular order).

Swap yields have a tried-and-true history of assisting with relative value
identification in European markets.
Many markets around the globe (and notably within Asia) have for a long
time run federal budgets that have at least been neutral if not in surplus,

Risk Management

and in the absence of being able to defer to swap yields would have no
other benchmark candidates in common with other markets globally.
As is perhaps now obvious in light of the two preceding points, if swap
yields were adopted in the U.S. market as a benchmark prototype, they
could easily translate into every market around the world.
Considering the possibility (at least as of this writing) of the U.S. fed-
eral government cutting its ties to federal agencies by no longer agree-
ing to back their debt implicitly, with the stroke of a pen the agencies
could very well become much more like non-Treasury instruments than
Treasury instruments. In this regard, if agencies were to become much
more creditlike anyway, then why not just revert to swap yields? This
question and others serve to highlight how the fluidity of the market-
place often affects the role and value of market benchmarks, and
investors are well advised to stay abreast of benchmark-related topics,
especially if the portfolio performance of interest to them is a perfor-
mance relative to a benchmark measure.

As pointed out in the appendix to Chapter 4, a benchmark may best be
thought of as a moving target rather than a static one. While this is obvi-
ous in the context of fast-moving markets, in some instances it can be just
as important when nothing really happens, as with fixed income securities.
While it may seem obvious to say that the value of a fixed income instru-
ment is going to be influenced by changes in interest rates, a variety of things
can impact the nature of those changes. Clearly, if a 10-year-maturity Fannie
Mae bullet is being quoted relative to the yield of the 10-year Treasury, then
the rise and fall in yield of the Treasury presumably will translate into the
rise and fall of the yield on the Fannie Mae issue. However, if a new 10-year
Treasury happens to come to market (as of this writing, a 10-year Treasury
comes to market every quarter) and becomes the new issue against which
the Fannie Mae security is quoted, then the yield spread of the Fannie Mae
relative to the Treasury may change. Its change would not be attributable
to anything new or different with Fannie Mae as a credit risk, nor, for that
matter, to anything new or different with the Treasury as a credit risk, but
solely because a benchmark Treasury rate has “rolled” into a new bench-
mark rate.
Another type of interest rate risk, and clearly a broader definition of the
“roll risk” just described, is “roll-down” risk. “Roll down” is a term used
to describe the fact that the yield curve typically has a slope to it, and as
time passes, a 10-year security is going to roll down into a 9-year maturity,
then an 8-year maturity, and so on. This phenomenon is called “roll down”
because the typical shape of the yield curve slopes upward, with yields at
shorter maturities being lower than yields for longer maturities. Thus,
rolling down the yield curve into shorter maturities generally would mean


rolling down into lower yield levels. However, this may not always be the
case. Indeed, even if the overall curve tends to have a normal upward slope
to it, there may be special cases where there is “roll-up.” For example, if a
widely anticipated newly issued Treasury were to come to market and with
strong demand, it may very well find itself “on special” and trading with a
lower yield, even though it has a maturity that is slightly longer than the
shorter-maturity Treasury that it is replacing.
In sum, benchmarks can be misleading if thought of only as static and
unchanging arbiters of relative value. They are fluid and dynamic, and if they
are indeed the enemy to be beaten for a value-oriented investor, then taking
the time to understand and appreciate the nature of a particular index would
be time well spent indeed.


Market Environment

& regulatory


This chapter continues with a more macro orientation toward investments,
examining tax, legal and regulatory, and investor-related issues. Specific cases
of how products and cash flows are affected by these macro dynamics, and
more general cases of how investment decision making is affected are presented.



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