BlackRock’sGuideto Fixed-IncomeRisk Management
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LibraryofCongressCataloging-in-PublicationData:
Names:Golub,BennettW.,author.|JohnWiley&Sons,publisher.
Title:BlackRock’sguidetofixed-incomeriskmanagement/BennettW. Golub.
Description:Hoboken,NewJersey:Wiley,[2023]|Includesindex.
Identifiers:LCCN2023007920(print)|LCCN2023007921(ebook)|ISBN 9781119884873(hardback)|ISBN9781119884897(adobepdf)|ISBN 9781119884880(epub)
Subjects:LCSH:Financialriskmanagement.|Fixed-incomesecurities—Risk management.|Investments—Riskmanagement.
Classification:LCCHD61.G6442023(print)|LCCHD61(ebook)|DDC 658.15/5—dc23/eng/20230505
LCrecordavailableathttps://lccn.loc.gov/2023007920
LCebookrecordavailableathttps://lccn.loc.gov/2023007921
CoverDesign:WileyandBlackRock CoverImage:©LiyaoXie/GettyImages
“And,ofcourse,stabilityisn’tnearlysospectacularasinstability.”
∼AldousHuxley, BraveNewWorld
2.7.1PrepaymentDuration
2.7.2Mortgage/TreasuryBasisDuration
BennettW.GolubandLeoM.Tilman
3.1ProbabilityDistributionsofSystematicRiskFactors59
3.2.3TheFirstPrincipalComponentandtheTermStructureof
3.2.4Example:HistoricalSteepenersandFlattenersoftheUS
4.3.1WeightingofHistoricalData
4.3.1.1ExponentialDecayWeighting
4.3.1.2AlternativeWeightingSchemesandStressScenarios
4.3.1.3EnhancingVolatilityResponsivenessDynamically
4.3.2Asynchronicity
4.3.2.1OverlappingCovarianceMatrix
4.3.3FactorModelStructure:Generalizations
4.3.3.1OptimizationoftheError-BiasTrade-Off
4.3.3.2MisspecificationandOmittedCovariation
4.3.4CovarianceMatrixEstimation:Summaryand Recommendations
4.4ExAnteRiskandVaRMethodologies93
4.4.1VaREstimationApproaches
4.4.2EnhancedHVaR 98
4.4.2.1EHVaRSystematicRiskMethodology 99
4.4.2.2EHVaRIdiosyncraticRiskMethodology 101
4.4.3VaREstimation:Summary 102
4.5IntroductiontoRiskDecomposition103
4.6AlternativeApproachestoRiskDecomposition104
4.6.1AComparisonoftheDifferentApproaches 106
4.7RiskDecompositionUsingCTR108
4.7.1Security-LevelContributionsandAggregations 108
4.7.2Factor-LevelContributionsandAggregations 109
4.7.3DecomposingContributiontoRiskintoAtomicContributions 111
4.7.4DecomposingContributiontoRiskintoExposure,Volatility, andCorrelation 113
4.7.5DecomposingContributiontoRiskUsingANOVA 114
4.8RiskDecompositionThroughTime116
4.9RiskDecomposition:Summary119 AppendixA.EHVaR:IdiosyncraticRiskEstimation119 AppendixB.EHVaR:Aggregation122 Notes 123
CHAPTER5
Market-DrivenScenarios:AnApproachforPlausibleScenarioConstruction125 BennettW.Golub,DavidGreenberg,andRonaldRatcliffe
5.1Introduction125
5.2ImpliedStressTestingFramework127
5.2.1Market-DrivenScenarioFramework 127
5.2.2ScenarioLikelihood 128
5.2.3FromLikelihoodtoProbability 129
5.2.4DecomposingtheScenarioZ-Score 131
5.2.5SpecifyingaCovarianceMatrix 133
5.3DevelopingUsefulScenarios134
5.3.1ScenarioDefinition 134
5.4AMarket-DrivenScenarioExample:Brexit136
5.4.1DescribingDifferentBrexitScenarioOutcomes 136
5.4.2IdentifyingKeyPolicyShocksinSoftBrexitScenario 137
5.5Conclusion142
Appendix:DecompositionofScenarioZ-Score143 Notes 143
CHAPTER6
AFrameworktoQuantifyandPriceGeopoliticalRisks145 CatherineKress,CarlPatchen,RonaldRatcliffe,EricVanNostrand,andKeminYang 6.1Introduction145
6.2SettingtheScene146
6.2.1ShortandSharp 147
6.2.2ShadesofGray 148
6.3BlackRock’sFrameworkforAnalyzingGeopoliticalRisks149 6.4GlobalTradeDeepDive149
6.4.1CalibratingtheShocks
6.5WhatIsAlreadyPricedIn?153
6.5.1IsItPricedIn?
6.5.2AdjustedImpacts
6.5.3AssessingLikelihood
6.5.4Takeaways
6.6TakingAction156
6.6.1KeyDrivers
6.6.2BGRI-SpecificAssets
6.6.3ThePathForward
CHAPTER7
7.1Introduction163
7.2ABriefHistoryofLiquidityRiskManagement164 7.3AFundLiquidityRiskFramework166
7.4AssetLiquidity166
7.4.1ImportanceofDataModelingforLiquidityRiskManagement
7.4.2AssetLiquidity:Days-to-Liquidate
7.4.3AssetLiquidity:CorporateBondTransactionCosts(T-Costs)
7.5RedemptionRisk169
7.5.1ManagingRedemptionsandOutflowRisk
7.6LiquidityStressTesting170
7.7ExtraordinaryMeasures171
7.8Fixed-IncomeDataAvailabilityLimitations171
7.8.1ModelingAssetLiquidity
7.8.2ModelingRedemption-at-Risk
7.8.3ModelingLiquidityOptimization
CHAPTER8 UsingPortfolioOptimizationTechniquestoManageRisk183 AlexUlitsky,BennettW.Golub,LeoM.Tilman,andJackHattem
8.1RiskMeasurementVersusRiskManagement183
8.2TypicalFixed-IncomeHedges185
8.3ParametricHedgingTechniques187
8.4GeneralizedApproachtoHedging189
8.4.1HedgingasConstrainedPortfolioOptimization
8.4.2MathematicalFormulation
8.4.2.1ExposureHedging
8.4.2.2ManagingaPortfolioAgainstaBenchmark
8.4.2.3StressScenarioHedging
8.4.3ExamplesofOptimizedRiskManagementStrategies
8.4.3.1CreatinganESGTiltWhileManagingaFixed-Income PortfolioRelativetoaBenchmark
8.4.3.2HedgingStressScenarioExposure
8.5AdvancedPortfolioOptimizationandRiskManagementTechniques207
8.5.1RiskBudgeting/Parity
8.5.2GoingBeyondaSingleFund/SinglePeriodinPortfolioRisk Management
8.5.2.1Multi-FundPortfolioConstructionandRiskManagement
8.5.2.2Multi-PeriodPortfolioConstructionandRiskManagement
8.5.2.3RiskManagementUsingScenarioOptimization
8.5.3Example:RiskBudgetingforFactor-BasedInvesting
CHAPTER11 PerformanceAttribution243
ReadeRyanandCarolYu 11.1Introduction243
11.2BrinsonAttributionandBeyond244
11.2.1ComparingMarketValueBrinsonAttributiontoBeta-Adjusted Attribution 250 11.3Factor-BasedAttribution252
11.4EquityFundamentalFactor-BasedAttribution256
CHAPTER12 PerformanceAnalysis259
MarkPaltrowitz,MarkTemple-Jones,ViolaDunne,andChristopherCalingo 12.1Introduction259 12.2PerformanceGovernance260 12.3PerformanceMetrics260
12.3.1.1AlphaTargetRatio
12.3.1.2WeightedPeerPercentile
12.3.1.3StrengthsandWeaknessesoftheATRandWeightedPeer Percentile
12.3.1.4AlphaDollars
12.3.1.5StrengthsandWeaknessesofAlphaDollars
12.3.2IndexPerformanceMetrics
12.3.2.1DirectTrackingBasisPoints(BP)
12.3.2.2StrengthsandWeaknessesofDirectTrackingBP
CHAPTER13 EvolvingtheRiskManagementParadigm267
BennettW.Golub,MichaelHuang,andJoeBuehlmeyer 13.1Introduction267
13.2TraditionalBuy-SideRiskManagementFramework268
13.3EvolvingtheIRMP:InPursuitofInvestmentRiskManagementatScale268
13.4RiskGovernance270
13.5SupportingRiskGovernanceThroughTechnology270 13.6ImplementingaRiskGovernanceFrameworkThroughAladdin271
13.7Aladdin’sRiskRadarExample271
13.7.1Aladdin’sRiskRadarOverview 271
13.7.2RulesandPortfolioSubscriptions
13.7.3ExceptionsandTasks
13.7.4ExceptionClassification
13.7.5RiskExceptionReportingandAudit
13.7.6WhatIsNextforTechnology-EnabledInvestmentRisk Oversight?
13.8Conclusion276
SECTIONII Fixed-IncomeRiskManagement—ThenandNow277
CHAPTER14
TheModernizationoftheBondMarket279
DanielVeiner,StephenLaipply,CarolynWeinberg,SamaraCohen,Vasiliki Pachatouridi,andHuiSienKoay
14.1ChartingtheEvolutionofBondMarkets279
14.1.1TheCurrentStateofBondMarketLiquidity 279
14.1.2TheModernizationofBondMarketStructure 281
14.1.3ContinuedGrowthinElectronicBondTrading 283
14.2TheDevelopmentofanIndex-BasedEcosystem285
14.2.1Fixed-IncomeETFs:ContinuedStrongGrowthandAdoption 285
14.2.2PortfolioTradingandFixed-IncomeETFs 286
14.2.3ContinuedGrowthinBondIndexDerivativesMarkets 288
14.2.4Fixed-IncomeETFOptions 288
14.3ImplicationsforInvesting,PortfolioManagement,andRisk Management289
14.3.1UseCasesforFixed-IncomeETFsandOtherIndexExposures 289
14.4TheFutureStateofPortfolioConstruction290
14.4.1PortfolioEngineeringandConstruction 290 14.5Conclusion290 Notes 291
CHAPTER15
TheLIBORTransition293
JackHattem
15.1Introduction293
15.2ImplicationstoPortfolioandRiskManagement295 15.3ShiftfromLIBORtoSOFR295
15.4RiskManagementImpactandCoordination297 15.5ReflectionsonaBenchmarkReforms298 Notes 300
CHAPTER16
DerivativesReform:TheRiseofSwapExecutionFacilitiesandCentralCounterparties301 EileenKielyandJackHattem
16.1TheCallforChange:2008GlobalFinancialCrisis301
16.1.1SEFs
16.1.2CCPs 302
16.2TheValueofDerivativesinFixed-IncomePortfolios302 16.3TradingFixed-IncomeDerivatives:TheRiseofSEFs304 16.4ClearingFixed-IncomeDerivatives:TheRiseofCCPs305 16.5CCPRiskMitigationTechniques306
16.5.1CCPRiskMitigationTechniques:WhatCouldGoWrong? 308
16.6TheCallforChange:MarketParticipantsAskforStrongerCCPs308 16.7Conclusion311 Notes 311
CHAPTER17
BennettW.GolubandConanCrum
19.5COVID-19Lessons:WhatWorkedandWhatNeedstobeAddressed357
19.6RecommendationstoEnhancetheResilienceofCapitalMarkets363
19.6.2.4CentralClearingCounterparties(CCPs)
19.6.2.5Equities
FrequentlyUsedAbbreviations
ABSAsset-BackedSecurities
ADVAverageDailyVolume
ANOVAAnalysisofVariance
APAuthorizedParticipant
APGAladdinProductGroup
ARRCAlternativeReferenceRatesCommittee
ARRsAlternativeReferenceRates
ATMAt-the-MoneyorAutomatedTellerMachine
ATRAlphaTargetRatio
AUMAssetsUnderManagement
AVaRAnalyticalVaR
BGRIBlackRockGeopoliticalRiskIndicator
BLKBlackRock
BoEBankofEngland
BPBasisPoint
BSRMFBuySideRiskManagersForum
BWICBidsWantedinCompetition
CCDCouponCurveDuration
CCostCostofCarry
CCPCentralCounterparty
CDFCumulativeDistributionFunction
CDSCreditDefaultSwap
CDXCreditDefaultSwapIndex
CIOChiefInvestmentOfficer
CLOCollateralizedLoanObligation
CMClearingMember
CMBSCommercialMortgage-BackedSecurities
CMRACapitalMarketRiskAdvisors
CPCommercialPaper
CPRConditionalPrepaymentRate
CROChiefRiskOfficer
CSACollateralSupportAgreement
CTFCollectiveTrustFund
CTRContributiontoRisk
CVaRConditionalVaR
DxSDurationTimesSpread
EHVaREnhancedHVaR
EMEmergingMarkets
EMHEfficientMarketHypothesis
ERMExchangeRateMechanism
ESExpectedShortfall
ESGEnvironmental,Social,andGovernance
€STREuroShort-TermRate
ETDExchange-TradedDerivative
ETFExchange-TradedFund
ETPExchange-TradedProduct
EWMAExponentiallyWeightedMovingAverage
FCAFinancialConductAuthority
FCMFuturesCommissionMerchant
FINRAFinancialIndustryRegulatoryAuthority
FSBFinancialStabilityBoard
FSOCFinancialStabilityOversightCouncil
FXForeignExchange
GDPGrossDomesticProduct
GFCGlobalFinancialCrisis
GNMAIIMBSGinnieMaeMortgage-BackedSecurity
HFHedgeFund
HRaRHistoricalRedemption-at-Risk
HRORHorizonRateofReturn
HVaRHistoricalVaR
HYHighYield
IBORsInterbankOfferedRates
ICTRIncrementalContributiontoRisk
IGInvestmentGrade
IMInitialMargin
IMAInvestmentManagementAgreement
IOSCOInternationalOrganizationofSecuritiesCommissions
IRInformationRatio
IRMPInvestmentRiskManagementParadigm
ISDAInternationalSwapsandDerivativesAssociation
ITMIn-the-Money
ITRMIdiosyncraticTailRiskMultiplier
KRBCKeyRateBucketConvexities
KRDKeyRateDuration
LCRLiquidityCoverageRatio
LDILiability-DrivenInvestment
LIBORLondonInterbankOfferedRate
LTVLoantoValue
LVNAVLowVolatilityNetAssetValue
MBSMortgage-BackedSecurities
MCTRMarginalContributiontoRisk
MDMahalanobisDistance
MDSMarket-DrivenScenario
MiFIDIIMarketsinFinancialInstrumentsDirective
MMFMoneyMarketFund
MPOMulti-PeriodOptimization
MRACMarketRiskAdvisoryCommittee
MSQEMean-SquaredError
MTBMortgage/TreasuryBasis
MWCBMarketWideCircuitBreaker
NAVNetAssetValue
NBFINon-BankFinancialIntermediation
OACOption-AdjustedConvexity
OADOption-AdjustedDuration
OASOption-AdjustedSpread
OAVOption-AdjustedValue
OCCOfficeoftheComptrolleroftheCurrency
OISOvernightIndexSwaps
OLSOrdinaryLeastSquares
OTCOver-the-Counter
OTMOut-of-the-Money
OTROn-the-Run
OTSOfficeofThriftSupervision
OWICOffersWantedinCompetition
P&LProfitandLoss
PCAPrincipalComponentsAnalysis
PEPPPandemicEmergencyPurchaseProgramme
PFMIPrinciplesforFinancialMarketInfrastructure
PQDPublicQuantitativeDisclosure
PROCPortfolioRiskOversightCommittee
PRVPurchaseRedemptionValue
PTFProprietaryTradingFirm
REITsRealEstateInvestmentTrusts
RFQRequestforQuote
RFRRisk-FreeRates
RPTRiskandPerformanceTargets
RQARisk&QuantitativeAnalysis
SARStandaloneRisk
SARONSwissAverageRateOvernight
SECSecuritiesandExchangeCommission
SEFSwapExecutionFacility
SOCPSecondOrderConicProgramming
SOFRSecuredOvernightFinancingRate
SONIASterlingOvernightIndexAverage
SPACsSpecialPurposeAcquisitionCompanies
STRMSystematicTailRiskMultiplier
T-costTransactionCost
TONATokyoOvernightAverageRate
TRACETradeReportingandComplianceEngine
TRSTotalReturnSwaps
TSOVTermStructureofVolatility
TSYTreasury
UCITSUndertakingsforCollectiveInvestmentinTransferableSecurities
UMBSUniformMortgage-BackedSecurities
USTUSTreasury
VaRValueatRisk
VMVariationMargin
WFHWorkfromHome
WoWWeek-over-Week
ZV0ZeroVolatilitySpread
Backinthedistantdaysofthemid-1980sIbeganmycareerfocusedonequitymarkets.
Overthenexttwodecades,theabundanceofpriceandvolumedata,alongwiththerelativelylimitedsetofvariablesrequiredtodescribeequityrisk,ledtothedevelopmentof fundamentalandstatisticalequityriskmodelsthatarenowubiquitousacrosstheassetmanagementindustry.
Induecourseitbecameobvioustomethatinordertounderstandinvestmentriskinall itsforms,someknowledgeoffixed-incomemarketsandproductswasalsonecessary.Many yearsbeforemyassociationwithBlackRock,Icameacrossabook, RiskManagement: ApproachesforFixedIncomeMarkets (2000)byBennettW.GolubandLeoM.Tilman. Irememberreadingitwithsomefascination.Thestatisticalconstructswere,atleastin part,similartothoseusedinequitymarkets.However,themarketsthemselveswerevery different.Nonetheless,therigorofthediscussionsandthepracticalityofthecontentswere incrediblyusefultomebackthen.
SomeyearslaterBenGolubandIbecamecolleagueswhenBlackRockacquired MerrillLynchInvestmentManagement,whereIwasthentheheadofitsRisk&QuantitativeAnalysisgroupinLondon.Thisbroughtmeforthefirsttimeintocontactwith BlackRock’sfixed-incomeanalyticsandriskmanagementteams.Myequitiesbackground combinedwithBlackRock’sfixed-incomeexpertisemadeforagoodmatch,andIwas appointedtheco-headwithBenGolubofamergedRisk&QuantitativeAnalysisgroup.
Overthesubsequent16years,muchhastakenplaceinbothmarketsandriskmanagement.Thecontrastsbetweenequitiesandfixed-incomeinvestingwere,inmanyrespects, palpable.Someofthecharacteristicsoffixed-incomesecuritiesbecameclearertome,suchas thelimitedtradingandevenmorelimitedpricedata,thelagsintheavailabilityofthelimited amountofpricingdata,theastoundingnumberofindividualsecurities,andthenonstandard termsandconditionsofsecurities.Real-worldriskmanagementmeantmakingnecessary compromisesfromtheequityideal.
Currently,changesandreformsaremovingfixed-incomemarketssomewhatcloserto themoreidealizedequitymarkets,makingcertaintypesofanalysesthatwereroutineinthe equitymarketspartiallyavailableforfixed-incomesecurities.
Thelast16yearshavealsocontainedsomemajormarketevents,includingtheGlobal FinancialCrisisandtheCoronaviruspandemic,thatchallengedthenotionthatevenexchange marketsoperateefficientlyallthetime.Someofthelaterchaptersinthisbookthatfocuson financialcrisescontainlessonsthatwelearnedthataregenuinelyworthremembering.
ThisbookintroducesthenotionofanInvestmentRiskManagementParadigm(IRMP). Thisisparticularlyusefulasareminderoftheneedtoenforceconsistentlevelsofrigoracross allofthefirm’sinvestmentprocesses.Havingaformalnotionofthisstandardizationhasbeen extremelyuseful,especiallywheninvestmentprocesseschangeoractivitiesareadded.
Historywillnotbekindtosomenotionsofriskmanagementthatturnouttobeformalizedmanifestationsofself-delusion.Otheranalyticsorframeworkswillbetterlastthe
testoftime.ButwhileIamcertainthatsomeofthenotionsdescribedinthisbookwill eventuallyneedtochange,justasmanywereeventuallyeditedoutofthefirstedition,many willstandthetestoftime.Thisbookpresentstechniquesandpracticesthatareactuallyused andareactuallyuseful.Irecommendittoinvestorsandriskmanagerswhowishtogetan insightintohowinvestmentriskmanagementiscontemporaneouslypracticedatamajor globalmulti-investmentprocessassetmanager.
EdFishwick ChiefRiskOfficer
BlackRock,Inc.
Summer2023
Preface
Changingmarketdynamics,technologicaladvances,andgeopoliticalstresseshavetransformedinvestmentriskmanagement.Asnewandbespokeproductshaveemerged,new risksandadditionalcomplexitieshavedrivenadvancesinriskmanagementprocessesand analytics.Consider,forexample,alltheforcedandrapidinnovationsthatarosefromthe Coronaviruspandemic.Giventheabundanceofchange,riskmanagershavehadtoadapt theirprocessesandtoolstoaddressmarketturbulence,structuralbondmarketchanges,productcomplexity,andincreasedregulatoryoversight.Additionally,riskmanagershavelearned totakeadvantageofsomeofthesetechnologicaladvances,resultinginbetteranalyticsand theabilitytoanalyzebiggerandbroaderdatasets.Anintellectuallycuriousriskmanagement culture,coupledwithrigorousriskmanagementprocessesandtechnologicalcompetence, facilitatesriskmanagers’abilitytorapidlyandeffectivelyadapttonewcircumstances.
Recognizingthedynamicnatureofinvestmentriskmanagementinformsusthatitis almostcertainthatsomeoftheideasandmethodologiespresentedinthisbookwillinevitably becomeobsoletethemselves.Similarly,thereinevitablyareimportantomissions,eitherintentionallyduetothelimitationsoftimeorareoutsidethewisdomandfirsthandknowledgeof theauthors.
Thisbookisaheavilyeditedandexpandededitionof RiskManagement:Approaches forFixedIncomeMarkets (2000)byBennettW.GolubandLeoM.Tilman(thefirstedition). Inthe23yearsfollowingtheoriginalEnglishlanguagepublication,muchhashappenedto reshapetheinvestmentriskmanagementlandscape.Forexample,theheightenedattention bymarketsandinvestorstoESG(environmental,social,andgovernance)characteristicswas neverenvisionedwhentheoriginalbookwaspublished.ThedefinitivebookonESGriskmanagementhasprobablynotbeenwrittenyet;thisbookintentionallyomitsmuchofthattopic, whiletheprofessionawaitsaconclusivestate-of-the-practicevolume.Also,whilecurrentlya hottopicandonethatcertainlyhasdemonstratedtheabilitytogeneratemultipleriskmanagementfailures,thisbookisintentionallysilentontheriskmanagementofcryptocurrencies; weawaitthosemarkets’riskmanagementprocessesmaturing.
Thetechnologicalintensityofinvestmentriskmanagementhasincreaseddramatically. Twenty-threeyearsago,technologywasnotnecessarilyattheforefrontofmostinvestment managementfirms.Now,technologyisoneofthecriticalsuccessfactors—allowingfirmsto continuetoevolvetomeetclients’needs,respondtomarketchangesandregulatoryrequirements,andcreateoperationalefficienciesandscale.Withimprovementsintechnology,firms arenowabletoperformtasksthatwerepreviouslytechnologicallyimpossibleorwouldtake toomuchtimeortoomuchexpensivehardwaretobeuseful.Wheneditingsectionsofthe originalbookforinclusioninthisnewedition,referencestoanalytictechniquesthatinvolved compromisingaccuracyforcomputationalefficiencywereremovedfromthemanuscript; thereismuchlessneedtocompromiseprecisionforthesakeofeconomizingcomputationalresources.TheimplicationsofMoore’sLaw,broadlyspeaking,continuetomakemore andmorecomputationalresourceseconomical.Cloud-basedapplications,forexample,can summonmassiveamountsofcomputationalpowerondemand.Organizationscanstore,
analyze,manipulate,andsynthesizewhatwouldhavebeenunimaginableamountsofdata morecheaplyandquicklythaneverbefore.Thesophisticatedandcreativeuseoftechnology,hasbecomeanessentialpartofeffectiveinvestmentriskmanagement.Havingtheright technologytomanageriskisnolongeraluxury;itisanecessity.
BlackRock’scommitmenttoinnovationandtheuseoftechnologyhasbeenoneofthe keydriversofitsongoingrobustgrowth.DevelopingandevolvingAladdinandleveraging technologyhasbeenpartofBlackRock’sfoundingvisionandhasenabledthefirmtobecome amassivescaleoperator,highlyefficient,integrated,anddynamic.Asthefirmgrowsand technologyevolves,Aladdincontinuestobeabest-in-classsolution,usedbyBlackRockto operateefficientlyatscale.ThesameAladdintechnologyusedbyBlackRockisalsoavailable andheavilyusedbymanymajorglobalfinancialinstitutions.
ThemotivationforthisbookoriginatedduetoaninquiryfromaBlackRockclientabout whenthefirsteditionwouldberevised.Initially,thisseemedtobearelativelystraightforward task,andtheprojectwasinitiatedin2017.Atfirst,theplanwastoupdatedata,tables, andexhibitsandremovetopicsthatwerenolongerrelevant.However,afterthisediting process,itbecameapparentthatsimplyupdatingthedataandremovingobsoletesections wouldbesorelyinadequategivenhowmuchmarkets,products,andriskmanagementhave evolved.Instead,itbecameclearthatiftheoriginalbookweretobeproperlyupdated,a substantialexpansionofthetopicscoveredwouldberequired.That,ofcourse,madecreating thesecondeditionamateriallygreatertask.Givenmythencurrentroleaschiefriskofficerof BlackRock,thistaskwouldhavebeenbeyondmyabilitytocomplete.In2018,Iconcluded thatifweexpandedthescopeofthebook,theonlyfeasiblepathforwardwastoaskmyfellow BlackRockcolleaguestocontributetheirexpertiseandenthusiasmandauthororcoauthor theneededchapters.Unliketheoriginalbook,whichwaswrittenasaunifiedwholeina singlevoice,theneweditionwouldincludechaptersonawiderangeoftopicswrittenby manyauthors.
BringingtogetherBlackRock’sleadersinriskmanagement,portfoliomanagement,trading,financialmodeling,psychology,andanalytics,thissuccessorbooktothefirstedition, nowtitled BlackRock’sGuidetoFixed-IncomeRiskManagement,representsacombination ofrevisedandupdatedchaptersfromtheoriginalbookandacollectionofnewstandalone chapterscoveringarangeofinvestmentriskmanagementtopics.Eachchapterhasbeen authoredbyBlackRock’scurrentorformerseniorsubjectmatterexperts.Whilethebook focusesprimarilyonfixed-incomepractices,analytics,andmodels,manyoftheconcepts presentedareequallymeaningfulinamulti-assetcontext.Thisbookcanfirstbeconsidereda practitioner’sguidetofixed-incomeriskmanagement,leveragingBlackRock’soverallinvestmentriskmanagementframeworkforoperatingaviableriskmanagementprogramatscale, heterogeneity,andcomplexity.
ORGANIZATIONOFTHEBOOK1
Thisbookisorganizedintothreesectionsandcoversthefollowingthemes:
(I) AnApproachtoFixed-IncomeInvestmentRiskManagement (II) Fixed-IncomeRiskManagement—ThenandNow (III) LessonsfromtheCreditCrisisandCoronavirusPandemic
SECTIONI:ANAPPROACHTOFIXED-INCOMEINVESTMENTRISK MANAGEMENT
InSectionI,wedescribethepillarsof BlackRock’sInvestmentRiskManagementParadigm (IRMP).Thisparadigmevolvedovermanyyearsasatooltobringconsistencyandstructure toBlackRock’sriskmanagementactivitiesacrossitsvariousinvestmentmanagementbusinessestoensurethatrisksareproperlyidentified,measured,governed,andreconciledwith actualperformance.TheIRMPrestsupononthefollowingfivepillars:
1. Exanteriskmeasurement
2. Riskgovernance(i.e.,havingandmaintainingagreeduponlevelsofrisks)
3. Portfoliomanagerrisk-returnawareness
4. Performanceattribution
5. Performanceanalysis
Eachcomponentoftheparadigmisdiscussedindetailinoneormoreofthefollowing chapters.Giventhevariousriskstowhichportfoliosareexposedandthediversityofmeasurementsavailable,severalchaptersexpanduponthefirstpillar, exanteriskmeasurement Examplesandcasestudiesareincorporatedtohelpillustratetheriskmanagementapproaches andanalyticspresented.
Chapter1providesanoverviewofriskmanagementatBlackRockanddiscussesseveralelementsthatunderpinastrongriskmanagementprogram.Thechapterreinforcesthe importanceofgovernanceandoversightandintroducesBlackRock’sapproachtoinvestmentriskmanagement.Tobeclear,though,establishingacomprehensiveandpervasiverisk managementprogramandculturerequirescommitmentandsupportfromalllevelsofan organization,startingwithseniormanagement.MycolleaguesandIwerefortunatetobe abletodevelopourideasandmethodologiesinsuchanenvironment.ThischapterwascoauthoredbymyselfandRickFlynn,managingdirectorintheRisk&QuantitativeAnalysis group.
Chapter2presentsparametricapproachestoriskmanagementandwasinitiallyincluded inthefirstedition.ThischapteralignswiththefirstpillarofBlackRock’sIRMP, exanterisk measurement.Thischapterincludesadiscussionofanalyticalandempiricaldurations,partial durations,interestratescenarioanalysis,andhorizonrateofreturnanalysis.Theparametric measuresofmarketriskcontinuetoformthebackboneofmoreelaborateandcompressive riskmethodologiesandtechniques,whichiswhywefeltthatitwasanimportantchapter torevisitandreviseinthisedition.Thischapterhasbeenupdatedwithmorerecentdata.It alsoincludesadditionalconcepts,suchasdurationtimesspread(DxS),authoredbyDavid Greenberg,formermanagingdirectorinTechnology&Operations—ArtificialIntelligence (AI)Labs.Additionally,weaddedanewsectiononoptionusageinportfoliomanagement, whichwasauthoredbyJackHattem,managingdirectorinthePortfolioManagementGroup. YuryKrongauz,managingdirectorintheFinancialModelingGroup,includedadditional detailsregardingwaveshockstotheKeyRateDurationsection.Thischapterwasupdatedby MatthewWang,managingdirectorintheFundamentalFixedIncomePortfolioManagement Group.
Chapter3reviewsthedynamicsofinterestrateshocksandwasalsopreviouslypublished inthefirstedition.TheconceptsinthischapterarealsopartofthefirstpillarofBlackRock’s
IRMPandcontainanintroductiontoprincipalcomponentanalysisaswellasaninvestigation oftheprobabilitydistributionofinterestrateshocks.Inthischapter,therelationshipbetween thefirstprincipalcomponentandthetermstructureofvolatilityisexploredandtheresults areappliedtothestudyofbigmarketmovedaysaswellasthehistoricalsteepenersand flattenersoftheUSTreasurycurve.ThischapterwasupdatedbyMatthewWang.
Chapter4focusesonestimatinganddecomposingportfolioriskandalsoalignswith thefirstpillarofBlackRock’sIRMP.Thischapterreviewsportfoliovolatilityestimationand factorstructure,alongwiththeempiricalchallengesassociatedwithestimatingcovariance matrices.ItcontainsanoverviewofValueatRisk(VaR)estimation,includingafocuson EnhancedHistoricalVaR(EHVaR),whichisaproprietaryapproachdevelopedformodeling theforwarddistributionofassetreturns.EHVaRblendstheadvantagesofbothparametric andnonparametricforecastingtechniques.Finally,thechapterdiscussesdecompositionof realizedriskandreturn.ThischapterwascoauthoredbyAmandeepDhaliwal,managing directorintheFinancialModelingGroup,alongwithTomBooker,directorintheFinancial ModelingGroup.
Chapter5introducestheMarket-DrivenScenarios(MDS)framework,whichisdesigned toprovidestructuretotheoftensubjectiveandadhocnatureofhypotheticalscenariogeneration.Macroeconomicfundamentalstypicallydrivethegeneraldirectionoffinancialmarket returns.However,tailrisks,whichcanbetriggeredbygeopoliticalevents,canarisethatare difficulttoforecastbutcanhavesignificantadverseeffectsonfundreturns.Asanelement ofthefirstpillar,thischapterhighlightstheuseofspecificeconometrictechniquesandthe applicationofadisciplinedmultistepprocesstocreateMarket-DrivenScenarios.TheMDS processisinherentlymulti-assetversusbeingparticularlyfixed-incomeoriented.Thischapter wascoauthoredbymyself,DavidGreenberg,andRonaldRatcliffe,managingdirectorinthe Analytics&QuantitativeSolutionsteamwithinBlackRockSolutions.
Chapter6usestheMDSframeworktoanalyzegeopoliticalrisksandassesstheirpotential marketimpactinasystematicway.Thechapterreviewsmarketresponsestounexpected historicalgeopoliticalshocksfrom1962–2019.Usingoneofthetopgeopoliticalrisksfrom 2019asanexample,thischapterdemonstratestheapplicationoftheMDSframework.This chapteralignswiththefirstpillaroftheIRMPandreinforcestheimportanceofscenario analysisandstresstestingportfolios.ItwascoauthoredbyCatherineKress,directorandhead ofGeopoliticalResearch&StrategywithintheBlackRockInvestmentInstitute;CarlPatchen, formervicepresidentintheRisk&QuantitativeAnalysisgroup;RonaldRatcliffe;EricVan Nostrand,formermanagingdirectorintheBlackRockSustainableInvestmentgroup;and KeminYang,formerassociateintheBlackRockInvestmentInstitute.Additionalcontributors includemyself,TomDonilon,chairmanoftheBlackRockInvestmentInstitute;andIsabelle MateosyLago,globalheadofBlackRock’sOfficialInstitutionsgroup.
Chapter7presentssomeapproachesformeasuringliquidityrisk,oneofthemanyinvestmentrisksthatdemandsrigorousandcontinuousoversight.Whileliquidityriskcanhave differentmeanings,thischapterfocusesonfundliquidityrisk.Asacomponentofthefirst pillar,thischaptercontainsabriefhistoryofhowliquidityriskmanagementhasevolved andcoversthevariouselementsofaliquidityriskmanagementframework,includingasset liquidity,redemptions,andextraordinarymeasures.Thischapterwascoauthoredbymyself; PhilipSommer,directorintheLiquidity&TradingResearchGroupwithinBlackRockSolutions;StefanoPasquali,headoftheLiquidity&TradingResearchGroupwithinBlackRock Solutions;MichaelHuang,managingdirectorintheRisk&QuantitativeAnalysisgroup; KristenWalters,formermanagingdirectorintheRisk&QuantitativeAnalysisgroup;and NikkiAzznara,vicepresidentinthePortfolioManagementGroup.
Chapter8presentsapproachesformanagingmarketriskinfixed-incomeportfoliosusing portfoliooptimizationtechniques.Anearlierversionofthischapterwaspreviouslyincluded inthefirstedition.However,ithasbeensignificantlyupdatedandtransformedtoreflectnew approachesforoptimization,includingmanythatarealsoapplicabletomulti-assetportfolios.Thechapterbeginswithadiscussionofthedifferencesbetweenriskmeasurements versusriskmanagementandcoverstypicalfixed-incomehedges.Then,thechaptertransitions todiscussparametrichedgingtechniques,generalizedapproachestohedging,andadvanced portfoliooptimizationandriskmanagementtechniques.Variousexamplesareincludedinthe chaptertodemonstratehowoptimizationapproachescanbeutilizedindifferentsituations. ThischapterdoesnotnecessarilyalignuniquelywithaspecificIRMPpillar.Rather,portfolio optimizationisapowerfulandversatiletoolthatallowsportfoliostobeengineeredfora varietyofreasons.ThischapterwasprimarilyauthoredbyAlexUlitsky,managingdirector intheFinancialModelingGroup.JackHattemprovidedsignificantupdatestothischapter.
Chapter9introducesthesecondpillar, riskgovernance, andalsointroducestheconcept ofriskscanstoidentifypotentialriskissues.Specifically,properlydesignedriskandexposure scanscanflagportfoliosandpositionsthatmaynotalignwithclientobjectivesorexpectations.Giventheincreasingsizeandheterogeneityofinvestmentprocessesandproducts, riskmanagersneedtoefficientlyanalyzeamultitudeofportfolios.Thischapterpresentsa basicunivariateriskscanframeworkthatusessimplealgorithmstoidentifypotentialrisk exceptions—whatcametobeknownatBlackRockasRiskandPerformanceTargets(RPT). Iwastheprimaryauthorofthischapter.RoryvanZwanenberg,directorintheRisk& QuantitativeAnalysisgroup,significantlycontributedtothischapter,alongwithKatieDay, managingdirectorintheRisk&QuantitativeAnalysisgroup.
Thethirdpillar, portfoliomanagerrisk-returnawareness,focusesontherelationship betweenportfolioandriskmanagers.Chapter10discussestheimportanceofriskmanagers workingtogetherwithportfoliomanagerstoensurethatrisksareproperlydetected,understood,andthenappropriatelymanagedforclients.Effectiveriskmanagementrequiresregular interactionwithportfoliomanagerstodiscussriskpositioningandcanincludeidentifying potentialadversebehavioralaspectsofinvesting.Thechapterconcentratesonbehavioral finance,anevolvingriskmanagementdomain,whichseekstoidentifycognitiveblindspots thatcanimpactinvestmentdecisions.Thechapterincludesdetailsondecision-makinganalyticssuchaslossaversion,dispositionbias,andtheendowmenteffect.Thechapteralsoincludes aframeworkforevaluatingbehavioralaspectsoftheinvestmentprocesses.Thischapterwas coauthoredbyEmilyHaisley,managingdirectorofthebehavioralfinanceinitiativesinthe Risk&QuantitativeAnalysisgroup,andNickyLai,directorintheRisk&Quantitative Analysisgroup.
Thefourthpillar, performanceattribution,decomposesinvestmentreturnsintotheir sourcesofperformance,providingportfolioandriskmanagerswithanunderstandingof thedriversofinvestmentresults.Chapter11coversapproachesandanalyticaltechniques thatpractitionerscanleveragetoconductperformanceattribution,includingBrinsonand factor-basedmethodologies.Thechapterprovidesmultipleexamplestodemonstratehow portfolioreturnscanbeviewedandinterpreted.ThischapterwascoauthoredbyReadeRyan, managingdirectorintheRisk&QuantitativeAnalysisgroup,andCarolYu,formervice presidentintheRisk&QuantitativeAnalysisgroup.
Thefifthpillar, performanceanalysis,presentsaframeworktoreviewaportfolio’s realizedperformancerelativetoitsbenchmarks,peers,andothercomparableaccounts. Chapter12discusseshowtomeaningfullymeasureaggregateplatformperformance, especiallyacrossaheterogeneoussetoffundswithdifferentbenchmarksandriskandperformancetargets.Thechaptercoversactiveperformancemetrics,suchasalphatargetratio,
weightedpeerpercentile,andalphadollars,alongwithindexperformancemetrics.Strengths andweaknessesofthevariousactiveandindexperformancemeasurementsarepresented. ThischapterwascoauthoredbyMarkPaltrowitz,managingdirectorandchiefperformance officerforBlackRockandtheheadoffixed-incomeandmulti-assetinvestmentrisk;Mark Temple-Jones,formerdirectorintheETF&IndexInvestmentsgroup;ViolaDunne,former managingdirectorintheRisk&QuantitativeAnalysisgroup;andChristopherCalingo, directorintheRisk&QuantitativeAnalysisgroup.
Chapter13markstheconclusionofthefirstsectionofthisbookanddiscussesfurther evolvingtheInvestmentRiskManagementParadigm.Giventhedynamicnatureoffinancial risk,continuouslyevolvingariskmanagementframeworktoaddressemergingrisksand changingmarketthemesiscrucialforagrowinginvestmentmanager.Thischapterstarts bycoveringthecharacteristicsofatraditionalbuy-sideriskmanagementframeworkand thendiscussesevolvingtheframeworktobettermanageamultiplicityofrisksatscale. BlackRockSolutions’AladdinimplementationoftheRiskRadarsystemispresentedasa tangibleexampleofhowriskgovernancecanbesuccessfullyexecutedatscale.Thischapter wascoauthoredbymyself;MichaelHuang;andJoeBuehlmeyer,directorintheAladdin ProductGroup.
SECTIONII:FIXED-INCOMERISKMANAGEMENT—THENANDNOW
Despiterapidtransformationinotherareasoffinancialmarkets,fordecades,thecore transactionalunderpinningsofbondmarketsremainedlargelythesame—hightouch, over-the-countermarketsdependentondealers’balancesheetswithonlylimitedtimely price,volume,andorderbooktransparency.However,intheyearsfollowingthe2008 GlobalFinancialCrisis,significantstructuralchangesinbondmarketshaveoccurred.This sectionbrieflydiscussessomeofthosebondmarketchangesoverthepast20years.
Chapter14discussesthemodernizationofthebondmarketandtheemergenceof fixed-incomeexchange-tradedfundproducts.Thechaptercoverstheevolutionofbond markets,thedevelopmentofindex-basedecosystems,theimplicationsforinvesting,portfoliomanagementandriskmanagement,andthefuturestateofportfolioconstruction. ThischapterwascoauthoredbyDanielVeiner,managingdirector,co-headofGlobal Trading;StephenLaipply,managingdirector,globalco-headofFixedIncomeETFs;Carolyn Weinberg,managingdirector,chiefproductinnovationofficerandco-headoftheGlobal ProductGroup;SamaraCohen,seniormanagingdirector,chiefinvestmentofficerofETF andIndexInvestments;VasilikiPachatouridi,managingdirector,headofiSharesFixed IncomeProductStrategyEMEA;andHuiSienKoay,director,leadIndexFixedIncome ProductStrategistforAPAC.
Chapter15discussesthecessationofLIBORandthemassiveundertakingrequiredto shifttoAlternativeReferenceRates(ARRs).Giventhetransition’ssizeandscope,themigrationawayfromLIBORrequiredasignificantamountofcoordinationandorganizationfrom variousmarketparticipants.Thischapteralsodiscussestheimplicationstoportfoliomanagementalongwithriskmanagement.ThischapterwaswrittenbyJackHattem.
Chapter16coversderivativesreformandtheriseofSwapExecutionFacilities(SEFs)and centralcounterparties(CCPs).FollowingtheGlobalFinancialCrisis,marketreformssought toimprovetransparencyinderivatives.Electronificationofmosttradingwasrequired,and counterpartycreditriskwasreducedbymandatingmuchgreaterusageofCCPs.Thischapter
