3.2 Risk Categories - a Definition of Terms

For the analysis of obligor-specific and market-sector-specific influence on bond price risk we make use of the following subdivision of ``price risk'', Gaumert (1999), Bundesaufsichtsamt für das Kreditwesen (2001).

  1. General market risk: This risk category comprises price changes of a financial instrument, which are caused by changes of the general market situation. General market conditions in the interest rate sector are characterized by the shape and the moves of benchmark yield curves, which are usually constructed from several benchmark instruments. The benchmark instruments are chosen in such a way so that they allow for a representative view on present market conditions in a particular market sector.

  2. Residual risk: Residual risk characterizes the fact that the actual price of a given financial instrument can change in a way different from the changes of the market benchmark (however, abrupt changes which are caused by events in the sphere of the obligor are excluded from this risk category). These price changes cannot be accounted for by the volatility of the market benchmark. Residual risk is contained in the day-to-day price variation of a given instrument relative to the market benchmark and, thus, can be observed continuously in time. Residual risk is also called idiosyncratic risk.

  3. Event risk: Abrupt price changes of a given financial instrument relative to the benchmark, which significantly exceed the continuously observable price changes due to the latter two risk categories, are called event risk. Such price jumps are usually caused by events in the sphere of the obligor. They are observed infrequently and irregularly.

Residual risk and event risk form the two components of so-called specific price risk or specific risk -- a term used in documents on banking regulation, Bank for International Settlements (1998a), Bank for International Settlements (1998b) -- and characterize the contribution of the individual risk of a given financial instrument to its overall risk.

The distinction between general market risk and residual risk is not unique but depends on the choice of the benchmark curve, which is used in the analysis of general market risk: The market for interest rate products in a given currency has a substructure (market-sectors), which is reflected by product-specific (swaps, bonds, etc.), industry-specific (bank, financial institution, retail company, etc.) and rating-specific (AAA, AA, A, BBB, etc.) yield curves. For the most liquid markets (USD, EUR, JPY), data for these sub-markets is available from commercial data providers like Bloomberg. Moreover, there are additional influencing factors like collateral, financial restrictions etc.,  which give rise to further variants of the yield curves mentioned above. Presently, however, hardly any standardized data on these factors is available from data providers.

The larger the universe of benchmark curves a bank uses for modeling its interest risk, the smaller is the residual risk. A bank, which e.g. only uses product-specific yield curves but neglects the influence of industry- and rating-specific effects in modelling its general market risk, can expect specific price risk to be significantly larger than in a bank which includes these influences in modeling general market risk. The difference is due to the consideration of product-, industry- and rating-specific spreads over the benchmark curve for (almost) riskless government bonds. This leads to the question, whether the risk of a spread change, the spread risk, should be interpreted as part of the general market risk or as part of the specific risk. The uncertainty is due to the fact that it is hard to define what a market-sector is. The definition of benchmark curves for the analysis of general market risk depends, however, critically on the market sectors identified.

We will not further pursue this question in the following but will instead investigate some properties of this spread risk and draw conclusions for modeling spread risk within internal risk models. We restrict ourselves to the continuous changes of the yield curves and the spreads, respectively, and do not discuss event risk. In this contribution different methods for the quantification of the risk of a fictive USD zero bond are analyzed. Our investigation is based on time series of daily market yields of US treasury bonds and US bonds (banks and industry) of different credit quality (rating) and time to maturity.