Risk Management and Derivatives Pricing

Abstract

After examining the implications of our theoretical term structure model on the different term structures that are relevant in pricing term structure derivatives we now answer the question on how the model can be used in risk management. The management of interest rate risk is especially concerned with rebalancing a fixed income portfolio exposed to interest rate risk due to the desired risk return characteristics. The types of interest rate risk considered to be of relevance in interest rate risk management are generally considered to be: (i) Market risk is the risk of changing prices due to general changes of the overall level of interest rates on default free securities, (ii) yield curve risk is considered the risk associated with non-parallel shifts in the yield curve, i.e. a reshaping of the yield curve due to, for example, steepening, flattening, or twisting, and (iii) credit risk which is related to altering security prices caused by changes in the creditworthiness of the issuer.