Economics Update (January-March 1998)

Different Types of Securities Require
Different Risk-Management Strategies

B ond prices tend to move together, but stocks tend to go their own way. This distinction requires completely different approaches to managing risks for these securities, according to Robert R. Bliss, an Atlanta Fed senior economist.

In an article in the Atlanta Fed's Economic Review (Fourth Quarter 1997), Bliss explains that the emphasis in equities management is on reducing risk through stock portfolio diversification. For interest rate-sensitive securities, portfolio management involves balancing a bond portfolio to achieve the desired exposure to systematic risk factors.

Hedging to reduce or eliminate the common factors influencing an interest rate-sensitive portfolio's value requires a model of interest rate behavior. This model may be formal, or it may be an ad hoc statistical model.

The most widely used method for hedging bond portfolios is duration immunization, which matches the Macaulay duration of assets and liabilities. Macaulay duration is based on the assumption that interest rates for all maturities move up and down in parallel. Even though this assumption is false, Macaulay duration hedging is still widely used. More advanced models assume that movements in interest rates have several components.

Bliss reviews and extends previous studies showing that term structure movements can be decomposed into three factors — changes in the general level of interest rates, changes in the slope of the term structure and changes in the curvature of the term structure. His empirical analysis shows that since 1970 the structure of these factors has not changed appreciably even though interest rate volatility has.

Bliss provides a numerical example demonstrating that hedging based on these three factors is superior to hedging based on the traditional method of Macaulay duration.

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