HOFIS 55 - Using DTS to Manage Credit Spread Risk

Question 1

Applications of DTS for fixed-income portfolio managers

Answer 1

• Forecast excess return volatility of credit securities (risk projection)
• Forecasting market betas to compute hedge ratios for market-neutral credit trades (hedging)
• Improve tracking the return of an index by matching contributions to spread duration (index replication)
• Imposing limits on the amount that can be invested in a single bond issuer (portfolio construction)
• Incorporating DTS into designing multifactor risk models (modeling)

Question 2

Return (excess retrun) of a bond due to a change in absolute spread

Answer 2

R_spread = spread duration * change in spread

• the risk factor is a parallel shift in the absolute spreads of the bonds
  across a sector
• risk exposure is measured in term of contribution to the spread duration D

Question 3

Volatility of excess return due to a change in absolute duration

Answer 3

Question 4

Excess Return in DTS framework

Answer 4

refers to the return due to changes in the spread

Question 5

Why is DTS useful for generating forecasts of spread volatility of bonds?

Answer 5

• because it uses the current spread levels to quickly adapt to changing market conditions (such as increased level of risk during 2007-2008 financial crisis)
• In contrast, traditional estimates based on realized spread volatility (using historical data) will be slower to adapt to changing market conditions
• In addition, the time period used for calculating realized spread volatility is subjective

Question 6

One potential solution to disadvantage of DTS-based approach in imposing a cap on the DTS contribution of any given bond issuer

Answer 6

• one could establish a two-tiered constraint with different thresholds for new and existing bond positions
  
  • stick to traditional approach of using market-weight limits to set ​hard limit on issuer exposures
• setting a higher DTS contribution limit for existing positions requires spreads to increase by more until we are required to sell out of existing bond positions to avoid breaching the DTS contribution limit

Question 7

DTS advantages for helping portfolio managers manage credit spread risk (Calibrating Credit Risk Factors)

Answer 7

1. Has a better assessment of the relative risks of different portfolios
2. Improves the accuracy of the risk projection by reducing the uncertainty in the estimation of risk factor volatilities
   
   • Prediction Spread Volatility
3. Can allow us to partition our model of the bond universe into fewer cells/groups
   
   • Allows us to combine cells with different credit ratings
   • with the assumption that systematic spread change accross industry is based on relative spreads