Assessing Interest Rate Risk Beyond Duration – Shift, Twist, Butterfly

Abstract:     
High fiscal deficits, a sharp rise in the issuance of sovereign debt from major developed economies, rising inflation expectations, and possible changes in central bank rates could cause the yield curves from around the world to change significantly. In the US, the yield curve has already experienced significant steepening in the past twelve months. This environment poses challenges for Fixed Income professionals who need to address possible non-parallel changes to the term structure.

This paper illustrates the capabilities of Shift-Twist-Butterfly (STB) factor models to help address these challenges. We provide a longer-term perspective on term structure changes in the Euro zone, US and Japan. Using four portfolio case studies, we show that the use of risk measures such as duration, convexity or key rate durations have some limitations and may not be very efficient. Therefore we show how these limitations can be efficiently overcome by the complementary use of advanced fixed income risk models based on STB interest rate risk factors.

Number of Pages in PDF File: 26

Keywords: Assessing Interest Rate Risk Beyond Duration, Shift Twist Butterfly, STB, factor models, rising inflation expectations, sovereign debt, term structure changes, Euro zone, US. Japan. risk measures factors

working papers series