Accounting for equity and currency factors
Whereas the factors that drive the performance of a portfolio of high quality bonds issued in a single country will predominantly be duration and credit, and may relate to the distribution of durations by comparison with a benchmark, when the portfolio is extended to include foreign currency bonds, or sub-investment grade corporate debt, the relevant risk factors will be more extensive.
EMA builds a true multi-asset model that combines factors derived from the fixed income, currency and equity markets in turn. This means that, where currency or equity based factors are material to the risk of a fixed income portfolio, the relationship is established. In particular, the modelling of corporate debt takes account of both the implied rating and the systematic characteristics of the underlying company so that, for example, a portfolio of US Energy company debt would have a different risk profile to that of UK Financial company debt.
This ability of the EMA system to look through the spreads on corporate bonds to the macro characteristics of the underlying fairly represents the fact that the bond risk profile is affected by the expected prospects of the issuer. Hence the analysis of a fixed income portfolio gains from EMA’s inclusion of equity based factors in its fixed income models.
As the corporate bond spreads are calibrated based on the systematic factor exposures of the issuing entity, in a VaR simulation the spread of the bond varies as the systematic factors are assumed to shift.
The overall attribution of risk also takes account of country and sector exposures that result from the mix of characteristics of the underlying companies.