2. Ron D'Vari, Ph.D.State Street Research1 INTEGRATED MULTI-FACTOR RISK MANAGEMENT AND PERFORMANCE ATTRIBUTION Ron D’Vari, Ph.D. Vice President, Fixed Income State Street Research & Management Visiting Lecturer, Boston University Presented At Risk ‘97 Seminar June 4, 1997, Chicago, IL

3. Ron D'Vari, Ph.D.State Street Research2 The Three Pillars of Integrated Financial Management and Performance Attribution Relative Valuation/ Process Honing Ex Post Market Monitoring/ Performance Attribution Ex Ante Risk/Exposure Measurement

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5. Ron D'Vari, Ph.D.State Street Research4  Factor Move Estimation and Monitoring  Factor Return Attribution Consistent with Risk Measurement  Relative Valuation  Investment Process Honing  Benchmark Setting/Improvement  Guideline/Mandate Improvements  Strategic Asset Allocation  Tactical Asset Allocation  Overlay Risk Hedges Ex-Post Market Move Monitoring and Decomposition Feedback Into The Investment Process

6. Ron D'Vari, Ph.D.State Street Research5 Elementary Risk Models

7. Ron D'Vari, Ph.D.State Street Research6 Multi-Factor Risk Models

8. Ron D'Vari, Ph.D.State Street Research7 Traditional Approaches  Decoupled Macro (overall plan) vs. Micro (Portfolio)  Macro: Highest risk-adjusted return via asset allocation  Micro: Focus on highest return but often ignore incremental risk (stock picking)  No Integrated Risk Management  Static Approach Using Forecast Returns  Relies on historical volatilities and correlations  Neglects short horizon risk  Ignores risk premium fluctuations  Does not take advantage of short term mispricing

9. Ron D'Vari, Ph.D.State Street Research8  Breaks up risk to its lowest common denominator  Integrates risk management into active management strategies  Use forward-looking view of volatility and correlations  Dynamic Approach  Forecast both expected returns and volatility  Focus on forecast risk-adjusted returns  Considers environment where expected returns are constant but volatility might have risen  Portfolio risk/return characteristics vs. Benchmark State-of-the-Art Approach

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14. Ron D'Vari, Ph.D.State Street Research13 FIXED-INCOME INTEGRATED MULTI-FACTOR RISK MANAGEMENT

15. Ron D'Vari, Ph.D.State Street Research14 MARKET

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18. Ron D'Vari, Ph.D.State Street Research17 VOLATILITY Volatility Risk  Volatility Sensitivity Prepayment and Call Risk  Function of Interest Rates and Volatility  Can be measured and managed by Prepayment Elasticities and Convexity

19. Ron D'Vari, Ph.D.State Street Research18 CREDIT Default  Spread  Measured and Managed by Effective Spread Duration (Sprdur) OTHERS Currency, Liquidity, Model, Operational, Counterparty, etc.

20. Ron D'Vari, Ph.D.State Street Research19 FACTORS

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22. Ron D'Vari, Ph.D.State Street Research21 FIXED-INCOME ANALYTIC

23. Ron D'Vari, Ph.D.State Street Research22 FIXED-INCOME ANALYTIC, cont.

24. Ron D'Vari, Ph.D.State Street Research23 Option Adjusted Risk Factors Absolute, Relative, Target Relative and Variance Curve Sensitivities by Sector  Effective Duration to Parallel Shift of Spot curve  Effective Twist Duration (yield curve steepenning)  Effective Barbell Duration (yield curve bulging)  Effective Convexity Sensitivity to Key Rates Sensitivity to Prepayment Factors Sensitivity to Volatility Spread Duration Risk Sensitivity to Currencies Sensitivity to Country Correlation Assumptions

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26. Ron D'Vari, Ph.D.State Street Research25 RECOMMENDED DAILY REPORTS Relative Curve Exposures, Yield, OAS, Convexity Absolute Curve Exposures Absolute and Relative Sector Exposures  % Invested and Duration Contribution Duration Bucket Exposure Full-Valuation Scenario Returns by Sector  Absolute and Relative  Factor Returns

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28. Ron D'Vari, Ph.D.State Street Research27 FIXED-INCOME PERFORMANCE ATTRIBUTIONS Two Approaches: Periodic Performance Attribution  For selected accounts with special benchmarks  Division to sub-periods (portfolio & benchmark) Portfolio action Market moves Cash Flows Daily Performance Attribution  For all portfolios and composites

29. Ron D'Vari, Ph.D.State Street Research28 GENERAL METHODOLOGY Detailed sub-period return attribution to:  Yield, roll-down, convexity, curve, sector, selection, and trading Bottom-Up Approach Geometric Linking Accounts for Cash Flows at sub-period levels

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31. Ron D'Vari, Ph.D.State Street Research30 YIELD/ AGING Beginning portfolio return under unchanged yield curve, OAS, and volatility scenario Includes accrued as well as accretion (aging) CURVE Beginning portfolio return with end period curve and volatility under OAS unchanged scenario less yield Decomposed to convexity, duration, twist, and butterfly Curve residual/selection component for periodic attribution

32. Ron D'Vari, Ph.D.State Street Research31 NONCURVE (OAS+VOL) Beginning Portfolio’s Buy-and-hold Total Return Minus [(Yield+Aging)+Curve Returns] Attributed to Credit Sector factor move (OAS) Security specific OAS move Selection/Residual

33. Ron D'Vari, Ph.D.State Street Research32 INTRA-PERIOD TRADING Calculated only for periodic approach Difference of the actual return of the portfolio from the buy-and-hold Portfolio’s actual total return (accounting) includes the effect of client-directed cash flows

34. Ron D'Vari, Ph.D.State Street Research33 SECURITY RETURN DECOMPOSITION Where:

35. Ron D'Vari, Ph.D.State Street Research34 PORTFOLIO RETURN DECOMPOSITION BENCHMARK RETURN DECOMPOSITION

36. Ron D'Vari, Ph.D.State Street Research35 PERFORMANCE ATTRIBUTION PITFALLS  Plain bad pricing  Non-contemporaneous pricing  Benchmark and Portfolio  Sectors  Curve calculation  Coarse generic pricing  Insensitive to sector specific factors, e.g.  WAM, WAC, seasoning, age, volatility

37. Ron D'Vari, Ph.D.State Street Research36 PERFORMANCE ATTRIBUTION PITFALLS, cont.  Inaccurate Analytic Tools  Mortgages and Asset-Backed Securities  Client-directed actions & cash flows that affect performance  Over Linking and Cross Factor Returns  Benchmark Changes and Inaccuracies  Sponsor initiated changes  Benchmark pricing  Forward benchmark vs. Backward benchmark  Exclusion/Inclusion of new asset classes

38. Ron D'Vari, Ph.D.State Street Research37 CONCLUSIONS Comprehensive Multi-Factor Model  Intuitive Factors  High Fidelity Yield Curve Sensitivity Model  Detailed Sector/Benchmark Comparison Analysis (BCA)  Scenario Analysis (SA) and Optimization (SO) Uniform Measurement of Risk and Implementation of Market Views  Across Hundreds of Portfolios with Different Benchmarks and Investment Objectives  Consistent Reporting

39. Ron D'Vari, Ph.D.State Street Research38 CONCLUSIONS (Cont’D) Other Benefits  Performance Attribution Multi-factor Accurate Consistent with Risk Model  Quantitative Security and Sector Valuation Framework Multi-factor valuation Accurate Consistent with risk and performance attribution models