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Unlike equity markets, fixed-income markets are generally less liquid despite being more prominent. This reduced liquidity can be attributed to several factors discussed in this section. Among these factors, the absence of uniformity in bond issues and the over-the-counter (OTC) nature of the markets play significant roles.
Digging deeper into the credit markets within fixed-income trading, we uncover additional complexities that contribute to dealing with illiquidity. In comparison to developed market government bonds and high-yield bonds, credit markets encounter liquidity challenges stemming from the following factors:
To tackle the growing complexities of credit market management, fixed-income portfolio managers utilize the following strategies:
Tail risk refers to the possibility of extreme events or outcomes occurring more frequently than traditional statistical models predict. These extreme events, often called “fat tails,” represent situations where the Probability of significant losses in a portfolio is higher than a normal distribution would suggest. In other words, the distribution's tails are fatter, indicating a greater likelihood of rare but impactful events. This concept challenges the assumption of a normal distribution commonly used in financial modeling and risk assessment. During market stress or crisis, correlations between different securities can increase, reducing the effectiveness of diversification strategies. This can lead to significant losses in investment portfolios, underscoring the importance of understanding and managing tail risk.
Value at Risk (VAR) is widely used for assessing tail risk in fixed-income portfolios. It estimates the minimum expected loss over a specified time horizon and confidence level. For instance, a daily VAR of 7% amounting to $2,000,000 indicates an anticipation of losing $2,000,000 on 7% of trading days annually.
Although VAR is a helpful starting point in tail risk management, it has limitations. Specifically, it underestimates losses during extreme events, central to tail risk. To address this, other “VAR variant” measures are employed:
Conditional VAR calculates the average of significant losses in the tail beyond the VAR threshold. This aims to quantify losses when they occur and rectify some of the deficiencies of traditional VAR.
Incremental VAR gauges the uncertainty introduced to a portfolio when positions are bought or sold, analyzing each position individually. For example, a portfolio manager could compute the traditional VAR and then re-evaluate incremental VAR after removing the lowest credit quality holding.
Relative VAR involves dividing the portfolio's VAR by an appropriate benchmark's VAR, similar to tracking error. While a favorable VAR figure might seem appealing, a significant deviation from the benchmark could indicate issues within the portfolio.
Tail risk's elusive nature complicates its management. Addressing tail risk ranges from obtaining extra insurance for a portfolio to anticipating unforeseen risks. Several strategies are available:
Question
Security correlations and market volatility most likely have the following relationship:
- Inverse.
- Positive.
- Mostly stable.
Solution
The correct answer is A.
The most likely relationship between security correlations and market volatility is inverse. When market volatility rises, security correlations decrease as investors seek diversification and non-correlated assets to manage risk during turbulent times. Conversely, security correlations may increase when market volatility subsides as asset movements synchronize.
B is incorrect. It implies that security correlations and market volatility move in the same direction, which is not the typical relationship observed in financial markets.
C is incorrect. Security correlations and market volatility often exhibit changes, especially during market stress or changing economic conditions.
Reading 22: Fixed Income Active Management: Credit Strategies
Los 22 (e) Discuss liquidity risk in credit markets and how liquidity risk can be managed in a credit portfolio
Los 22 (f) Describe how to assess and manage tail risk in credit portfolios