Identifying Interest Rate Curve Risk

While interest rates remain steady, change in Washington often means change in perspective and direction. If the stimulus bill is passed, what happens if the market starts to feel interest rate pressure again? Let’s look back to the a recent interest rate market event and how risk managers were able to react to it.  

The two months of June and July of 2019 brought unforeseen volatility 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 group- think 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 and then determine if the risk exceeds the benefit of holding the position. Traders are famous for advocating on behalf of their positions and for stating “that won’t happen” when a risk manager poses an assumption that impact the trader’s position. However, it is imperative the risk manager know the answer to the question “what if it does happen?” prior to the event.

Market participants have an aggregate idea of the potential outcome when the market behaves ‘normally’. 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 a ‘non-normal’ outcome.

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Identifying the Negative Outcomes

Using post-trade stressing tools, risk managers create ‘what if’ scenarios to determine the potential profit/loss of: a steepening/flattening of the yield curve during rising/declining rate environments, an inverted yield curve during a rising/declining rate environment, a spike/dip in short-term rates due to a geopolitical event and/or eroding liquidity levels, but to name a few. 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. What happens if options are added to these positions or if these positions/strategies are created entirely out of options? This would introduce entirely new categories of risk and would require the risk manager to consider the following:

• Shocking relative volatility levels of contracts in a particular segment of the yield curve (all of the monthly contracts of the 10yr T-note, for example), as well as across the entire yield curve (30yr,10yr, 5yr, 2yr, Eurodollars, Fed Funds)
• Shocking volatility shapes (skew) on each piece of the yield curve as well as across the entire yield curve.
• Calculating the theta of holding these positions each day and evaluating the effect of option expiration dates on the option behavior (for example, does this option expire before the upcoming Fed Meeting but others do not?).

The complexity of managing multi-dimensional risk (price/time/volatility/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 the proper tools at his/her disposal, the risk manager is essentially driving while wearing a blindfold.

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