Recent pricing dislocations in U.S. fixed-income markets have illustrated there is more to hedging a liability’s interest rate risk than simply matching its duration. Basis risk – in the context of liability hedging – is the risk that the changes in the market value of assets, designated as a hedge, will deviate from the changes in the value of the appropriate liability benchmark.
Diversification is one of the few reliable ‘free lunches’ in asset markets. Nevertheless, investors do not always extract the best from the available benefits. Many portfolios still carry some concentrated risk exposures. And when diversification is pursued, it often occurs under the shotgun approach of increasing the number of return sources, albeit guided by a focus on correlation.
This report is the first of a two-part series that proposes a more rifle-shot approach to diversification. It suggests a general process for improving the asset class mix of an existing portfolio. The method involves identifying the underlying fundamental risks to which the portfolio is most exposed, the purposefully diversifying towards assets that address these risks.
Part B of the series discusses the hunt for excess returns.
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