Estimating and Hedging Most Probable Extreme Changes in Multicurrency Term Structures

Abstract

For both fixed-income investors and risk managers, the assessment of likely term structure changes is crucial to portfolio value and risk. This study presents an innovative approach to trace the most probable extreme changes in term structures and thus minimize the risk exposure of multicurrency fixed-income portfolios. More precisely, the authors define a measure of the magnitude of term structure changes. The authors then identify the most probable changes for any given level of magnitude. History provides evidence of the most probable changes in term structures being linearly related for each possible level of magnitude. The authors further show that market agitation has a limited impact on this linear relationship. Consequently, the most probable changes in multicurrency term structures can be deduced from the most probable change in a single reference rate (e.g., the USD 10Y swap rate). The resulting model implies a straightforward strategy to hedge multicurrency fixed-income portfolio against interest rate risk.