Abstract
This paper tries to show that changing the funding assumptions in calculating marginal contributions to tracking error can significantly enhance the interpretation and acceptance of portfolio risk decomposition and implied alpha calculation. While standard risk software assumes that active positions are funded from cash, this is not intuitive for the portfolio managers involved. A long position in US 10 years could also be funded from 5-year bonds in the US (intracountry spread trade), from a combination of cash and 5-year bonds (barbell trade), from a short position in Canada (intercountry spread trade) or from a short position in 10-year corporate bonds (credit spread trade). Thinking of risk positions as long/short trades allows portfolio managers to monitor risk quickly and decompose it into meaningful trade categories.
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