OVERVIEW OF AN INTEGRATED QUANTITATIVE FRAMEWORK IN FIXED-INCOME PORTFOLIO MANAGEMENT

1. OVERVIEW OF AN INTEGRATED QUANTITATIVE FRAMEWORK IN FIXED-INCOME PORTFOLIO MANAGEMENT February 17, 1999 Global Association of Risk Professional Boston Ron D’Vari, Ph.D., CFA

2. The Three Pillars of Fixed-Income Portfolio Management Ex Ante Market Expectations and Risk/Exposure Measurement Portfolio Synthesis & Optimization Relative Valuation and Process Honing Ex Post Market Monitoring and Performance Attribution Ron D'Vari

3. ROLE OF MULTI-FACTOR MODELS IN FIXED-INCOME PORTFOLIO MANAGEMENT • Uniform and Consistent Implementation of Market Views on Risk/Return • Multiple accounts • Distinct investment guidelines • Varied benchmarks • Proper Integration of • Sector views in portfolio synthesis • Changing view of risk environment • Performance attribution in process improvement • Uniform Framework for Portfolio Positioning • Standardized Multivariate Risk Reports • Transparent and frequent (daily) • Comprehensive yet easy to understand • Address multidimensionality of risk • Separation of Trading from Portfolio Management Ron D'Vari

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5. Ex-Post Market Move Monitoring and Decomposition • Factor Move Estimation and Monitoring • Factor Return Attribution Consistent with Risk Measurement Feedback Into The Investment Process • Portfolio Re-optimization • Sector/Quality Relative Valuation • Tactical SectorAllocation • Strategic Asset Allocation • Overlay Risk Hedges • Investment Process Honing • Evaluation of Asset Mix Policy Ron D'Vari

6. Elementary Risk Models Ron D'Vari

7. Multi-Factor Risk Models Ron D'Vari

8. 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/bond 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 Ron D'Vari

9. State-of-the-Art Approach • Breaks up risk in to its lowest common denominators • Integrates risk management with active management strategies • Use forward-looking view of expected returns, volatilities 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 Ron D'Vari

10. FIXED INCOME RISKS CURVE SHAPE VOLATILITY CREDIT OTHERS - Spread Term Structure - Spread Volatilities and Correlations - Per Sector/Quality - Residual Per Issuer - Prepayment - Currency (V/C) - Sovereign - Liquidity Premium - Model - Legal - Political - Taxes - Parallel - Twist - Butterfly - Higher Principal Components - Residual - Short End - Long End - Volatility Correlations - Historical vs. Implied Ron D'Vari

11. EQUITY RISKS MARKET VOLATILITY FUNDAMENTALS SECTORS - Domestic - Foreign - Volatility Correlations - Historical and Option-Implied - Domestic Equities - Foreign Equities - Beta Risk - Correlations Risk - Return Momentum - Technology - Financial - Services - Telecommunications - Transportation - Utilities - Energy - Healthcare - etc. - Size - Earnings: P/E - Value: B/P - Growth - Dividend Yield - Leverage [D/(D+E)] - Liquidity - Foreign Exposure Ron D'Vari

12. HARD TO QUANTIFY RISKS EMERGING MARKETS STRUCTURED PRODUCTS CUSTODIAL MODEL - Insufficient Basis - Oversimplification - Missing Significant Factors - Implementation Errors - Insufficient Data - Unaccounted Structural Changes - Accurate Accounting - Settlement & Disposition - Discrepancy Reporting - Information Accuracy - Timely Monitoring - Tradable Pricing - Securities Lending, Cash Management, etc. - Credit - Administration Errors - Insufficient Data/ Information - Insufficient Credit Legal/Political Risk Methodology - Data Incomparability - Convertibility - Expropriation - Tradability - All Other Risks - Basis Risk - Liquidity Risk - Counterparty Risk Ron D'Vari

13. RISK MODELS • BENCHMARK • COMPARISON • BENCHMARK • VARIANCE • SCENARIO ANALYSIS • (STRESS TESTING) • VAR (NONLINEAR) • PERFORMANCE • ATTRIBUTION • RISK ADJUSTED • RETURN • RELATIVE • VALUATION ADDED-VALUE FINANCIALRISK MANAGEMENT FORWARD VIEW REAR VIEW SYNTHESIS • STRATEGIC/TACTICAL • ASSET ALLOCATION • SCENARIO • OPTIMIZATION • RELATIVE VALUE • ANALYSIS Ron D'Vari

14. INTEGRATED FIXED-INCOME MULTI-FACTOR MODEL Ron D'Vari

15. MARKET Ron D'Vari

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18. 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 Ron D'Vari

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

20. FACTORS Ron D'Vari

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22. FIXED-INCOME ANALYTIC • Accurate Stochastic Interest Rate Term Structure Models • Arbitrage Free One-Factor Models • Arbitrage Free • Lognormal with Mean Reversion • Term Structure of Volatility • Stable Forward Curve • Efficient and Accurate Implementation • Arbitrage Free Two-Factor Models • Term Structure of Volatility • Mortgage Passthroughs, CMO’s, Special Securities • Monte Carlo Simulation • Yield Curve Estimation Methodology (Fitting) • Volatility Forecasting Methodology Ron D'Vari

23. FIXED-INCOME ANALYTIC, cont. • Option Adjusted Sensitivity Analysis • Curve Reshaping • Spread • Volatility • Prepayment Models for Agency and Non-agency Mortgages • Extensive Security Modeling Tools • Call, Put, Conversion, Sinking Fund Structures, • Make-Whole Calls • CMO’s, Asset-backed Securities, • Floating Instruments with Caps/Floors/Collars, • Multi-index Floating • Derivative’s Structuring Tools • Exchange and OTC Traded • Fixed for Floating, CMT, and Fixed-for-Fixed Swaps • Forward Swaps and Swaptions • Credit Derivatives Ron D'Vari

24. Option Adjusted Risk FactorsAbsolute, Relative, Target Relative • 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 (for tracking error) Ron D'Vari

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26. DAILY RISK REPORTS • Relative Curve Exposures, Yield, OAS, Convexity • Absolute Curve Exposures • Absolute and Relative Sector Exposures • % Invested and Duration Contribution • Duration/Sector/Quality Bucket Exposure • Full-Valuation Scenario Returns by Sector • Absolute and Relative • Factor Returns Ron D'Vari

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 Ron D'Vari

28. GENERAL METHODOLOGY • Detailed sub-period return attribution to: • Yield, roll-down, convexity, curve, sector/quality, selection, and trading • Bottom-Up Approach • Geometric Linking • Accounts for Cash Flows at sub-period levels Ron D'Vari

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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 Ron D'Vari

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 Ron D'Vari

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 Ron D'Vari

33. 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 Ron D'Vari

34. PERFORMANCE ATTRIBUTION PITFALLS, cont. • 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 Ron D'Vari

35. 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 Ron D'Vari

36. 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 Ron D'Vari