Quantification of spread risk by means of historical simulation

Abstract

Modeling spread risk for interest rate products, i.e., changes of the yield difference between a yield curve characterizing a class of equally risky assets and a riskless benchmark curve, is a challenge for any financial institution seeking to estimate the amount of economic capital utilized by trading and treasury activities. With the help of standard tools this contribution investigates some of the characteristic features of yield spread time series available from commercial data providers. From the properties of these time series it becomes obvious that the application of the parametric variance-covariance-approach for estimating idiosyncratic interest rate risk should be called into question. Instead we apply the non-parametric technique of historical simulation to synthetic zero-bonds of different riskiness, in order to quantify general market risk and spread risk of the bond. The quality of value-at-risk predictions is checked by a backtesting procedure based on a mark-to-model profit/loss calculation for the zero-bond market values. From the backtesting results we derive conclusions for the implementation of internal risk models within financial institutions. © 2008 Springer-Verlag Berlin Heidelberg.