INTEGRATED MULTI-FACTOR RISK MANAGEMENT AND PERFORMANCE ATTRIBUTION

1. 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 State Street Research

2. The Three Pillars of Integrated Financial Management and Performance Attribution Ex Ante Risk/Exposure Measurement Relative Valuation/ Process Honing Ex Post Market Monitoring/ Performance Attribution State Street Research

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4. Ex-Post Market Move Monitoring and Decomposition • Factor Move Estimation and Monitoring • Factor Return Attribution Consistent with Risk Measurement Feedback Into The Investment Process • Relative Valuation • Investment Process Honing • Benchmark Setting/Improvement • Guideline/Mandate Improvements • Strategic Asset Allocation • Tactical Asset Allocation • Overlay Risk Hedges State Street Research

5. Elementary Risk Models State Street Research

6. Multi-Factor Risk Models State Street Research

7. 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 State Street Research

8. State-of-the-Art Approach • 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 Street Research

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13. FIXED-INCOME INTEGRATED MULTI-FACTOR RISK MANAGEMENT State Street Research

14. MARKET State Street Research

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17. 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 State Street Research

18. CREDIT • Default • Spread • Measured and Managed by Effective Spread Duration (Sprdur) OTHERS • Currency, Liquidity, Model, Operational, Counterparty, etc. State Street Research

19. FACTORS State Street Research

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21. FIXED-INCOME ANALYTIC State Street Research

22. FIXED-INCOME ANALYTIC, cont. State Street Research

23. Option Adjusted Risk FactorsAbsolute, 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 State Street Research

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25. 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 State Street Research

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27. 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 State Street Research

28. 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 State Street Research

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30. 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 State Street Research

31. 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 State Street Research

32. INTRA-PERIODTRADING • 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 State Street Research

33. SECURITY RETURN DECOMPOSITION Where: State Street Research

34. PORTFOLIO RETURN DECOMPOSITION BENCHMARK RETURN DECOMPOSITION State Street Research

35. 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 State Street Research

36. 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 State Street Research

37. 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 State Street Research

38. 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 State Street Research