Market Risk 101: Quantifying spread risk in interest rate products
by Dave Zurkowski
Identifying and Quantifying Interest Rate Curve Risk
The past two months (June and July of 2019) have brought unforeseen volatility back into the interest rate arena. During this period, the Federal Reserve did an ‘about-face’ regarding the direction of interest rates in the US. This came as an unwelcome surprise to market participants as most traders, speculators and hedgers were prepared for a rising or unchanged interest rate environment, with very little attention paid to the thought of declining interest rates. This groupthink caused a rush to exits to reverse or close out existing positions.
Market risk managers are tasked with evaluating and diffusing these situations on a daily basis. A proactive risk manager will attempt to determine the outcome of potential events before they occur. They view the risk outside the groupthink box and consider what happens if the market behaves in a manner 180 degrees removed from the consensus expectation.
The tools used to expose and mitigate these events are often known as ‘what if’ stressing scenarios. This practice allows risk managers to view the outcome of yield curve shifts to determine if the risk exceeds the benefit of holding the position. Traders are stereotypically regarded for taking a ‘that will never happen’ approach when risk managers pose assumptions that would negatively impact their position. However, it is imperative for the risk manager to understand what could happen prior to the event.
Market participants have an aggregate idea of their position’s behavior when the market behaves as expected. The key goal of risk management is to identify the outliers to ‘normal’ and then determine if the risk taken is warranted based on the probability of an unexpected outcome.
Identifying the Negative Outcomes
Using post-trade stressing tools, risk managers create ‘what if’ scenarios to determine the potential profit/loss for situations such as:
A steepening or flattening of the yield curve during rising or declining rate environments
An inverted yield curve during a rising or declining rate environment
A spike or dip in short-term rates due to a geopolitical event and/or eroding liquidity levels
These scenarios may be contrary to the current market wisdom at any point in time, but they must be evaluated daily as the associated risk needs to be identified before the ‘non-normal’ events are set in motion.
The examples given above pertain to positions containing only underlying securities. If options are added to these positions or if these positions or strategies are created entirely out of options, a new category of risk would be introduced, requiring the risk manager to consider:
Shocking relative volatility levels of contracts in a particular part of the yield curve, for example, all of the monthly contracts of a 10 year T-note, as well as across the entire yield curve (30 year,10 year, 5 year, 2 year, Eurodollars)
Shocking volatility shapes (skew) on each piece of the yield curve and across the entire yield curve
Calculating the theta of holding these positions each day
Evaluating the effect of option expiration dates on the option behavior
The complexity of managing multi-dimensional risks, including price, time, volatility and skew, calls for robust ‘what if’ tools that can simulate potential market events. These risks are real and should be evaluated as often as the ‘normal’ market expectation. Without proper tools at their disposal, risk managers are driving whilst blindfolded.