VOLATILITY
The portfolio manager must define interest rate volatility, specifying it as a function of both maturity and term. Generally, volatility is a declining function of both maturity and term. Historical data substantiate this proposition. The natural implication of this proposition is that for a given portfolio duration, the portfolio’s shorter securities are expected to be more volatile in a yield sense or more risky than its longer bonds. For substantiation of this point, the portfolio manager need only consider the OTC market for options on U.S. Treasury securities to understand the market’s pricing of yield curve volatilities.
The assignment or selection of volatility along international yield curves is an important decision for the global fixed income portfolio manager. It not only affects the valuation of imbedded and actual call options but it affects the overall risk adjustments of the portfolio. Risk-adjusted durations, risk-adjusted convexities, and risk-adjusted portfolio yield are partially a function of volatility. Therefore, strategically, the portfolio manager may want to buy volatility on a particular part of a yield curve and sell it at another part to secure the desired risk-adjusted factors.
Volatility itself is an important characteristic that must be accounted for and managed by the portfolio manager in the following contexts:
1. Option hedging of positions. As volatility increases, the value of a given option will increase. Therefore, the popular ...
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