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Duration times spread. A New Measure of Spread Exposure in Credit Portfolios. Inquire - Athens 17 October 2006 Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen, Olaf Penninga. Agenda. Introduction & Conclusion

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    1. Duration times spread A New Measure of Spread Exposure in Credit Portfolios Inquire - Athens 17 October 2006 Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen, Olaf Penninga Duration times Spread

    2. Agenda • Introduction & Conclusion • Using Duration times Spreads (DTS) to Capture volatility • Estimating Portfolio Risk • Scope of Duration times Spread (DTS) • Implications Portfolio Management Duration times Spread

    3. How to capture changing volatility? • Spread change volatility by credit rating, trailing 36-month • Using past volatility to measure credit risk means lagging the market • Using only ratings to measure current risk means lagging the market x 4 Duration times Spread

    4. Examples • Historical Volatility is a bad predictor for future volatility Duration times Spread

    5. Conclusions • Volatilities in credit markets unstable. Ratings not capable to capture time series or cross-sectional volatilities • Spread information can be used to capture current volatility • Major shift for credit portfolio management; portfolios should be managed using Duration times Spread (DTS) instead of Spread Duration • Using DTS leads to a different approach for portfolio management, risk management and performance attribution Duration times Spread

    6. Agenda • Introduction & Conclusion • Using Duration times Spreads to Capture volatility • Estimating Portfolio Risk • Scope of Duration times Spread (DTS) • Implications Portfolio Management Duration times Spread

    7. Modeling return and risk • Comparing different model specifications • Absolute Spread Changes • Relative Spread Changes Duration times Spread

    8. Systematic risk: spread volatility vs Spread Level • Time series volatility of systematic spread changes (1989-2005) • Strong linear relationship between Spread volatility and Spread level Duration times Spread

    9. Specific risk: spread volatility vs Spread Level • Pooled idiosyncratic spread volatility per sector-rating-spread bucket (1989-2005) • Strong linear relationship between Spread volatility and Spread level Duration times Spread

    10. Stability of linear relationship • Yearly regression of Spread volatilty vs Spread level, including and excluding HY, (1990-2004) • Far more stable relationship compared to stability of overall market or rating buckets Duration times Spread

    11. Agenda • Introduction & Conclusion • Using Duration times Spreads to Capture volatility • Estimating Portfolio Risk • Scope of Duration times Spread (DTS) • Implications Portfolio Management Duration times Spread

    12. Using DTS to measure credit risk • Excess Return Volatility versus DTS, (1989-2005) • Same risk for same DTS: Low spread-high duration bonds are as risky as high spread-low duration bonds Duration times Spread

    13. How accurate are risk estimates for portfolios? • Mean and Standard Deviation of Normalized Excess Return Realizations per bucket (1989-2005) • Using Relative spread change + DTS leads to unbiased estimation of risk Duration times Spread

    14. How accurate are risk estimates for portfolios? • Distribution of standardized excess returns, (1992-2005) • Using Relative spread change + DTS leads to less outliers Duration times Spread

    15. Agenda • Introduction & Conclusion • Using Duration times Spreads to Capture volatility • Estimating Portfolio Risk • Scope of Duration times Spread (DTS) • Implications Portfolio Management Duration times Spread

    16. Does DTS hold for European Credit markets? • Excess Return Volatility versus DTS (2000-2005) • Linear relationship between DTS and Credit return volatility holds for Europe as well Duration times Spread

    17. Does DTS hold for Senior as well as subordinated Credit markets? • Excess Return Volatility versus DTS (2000-2005) • Same Linear relationship between DTS and Credit return volatility holds for senior and subordinated credits Duration times Spread

    18. Agenda • Introduction & Conclusion • Using Duration times Spreads to Capture volatility • Estimating Portfolio Risk • Scope of Duration times Spread (DTS) • Implications Portfolio Management Duration times Spread

    19. Implications for Portfolio Management • Better insight in e.g sector exposures • Calculations of betas of portfolio • Better calculation of risks (volatilities, tracking errors) of portfolio • Determination of hedging strategies for credits • Performance attribution Duration times Spread