The performance of alternative interest rate risk measures and immunization strategies under a Heath-Jarrow-Morton framework

The Heath-Jarrow-Morton (HJM) model represents the latest in powerful arbitrage-free technology for modeling the term structure and managing interest rate risk. Yet risk management strategies in the form of immunization portfolios using duration, convexity, and M-square are still widely used in bond portfolio management today. This study addresses the question of how traditional risk measures and immunization strategies perform when the term structure evolves in the HJM manner. Using Monte Carlo simulation, I analyze four HJM volatility structures, four initial term structure shapes, three holding periods, and two traditional immunization approaches (duration-matching and duration-and-convexity-matching). I also examine duration and convexity measures derived specifically for the HJM framework. In addition I look at whether portfolios should be constructed randomly, by minimizing their M-squares or using barbell or bullet structures. I assess immunization performance according to three criteria. One of these criteria corresponds to active portfolio management, and the other two correspond to passive portfolio management. Under active portfolio management, an asset portfolio is successfully immunized if its holding period return is greater than or equal to the holding period return of the liability portfolio. Under passive portfolio management, the closer the returns of the asset portfolio to the returns of the liability portfolio, the better the immunization performance.; The results of the study suggest that, under the active portfolio management criterion, and with the duration matching strategy, HJM and traditional duration measures have similar immunization performance when forward rate volatilities are low. There is a substantial deterioration in the immunization performance of traditional risk measures when there is high volatility. This deterioration is not observed with HJM duration measures. These results could be due to two factors. Traditional risk measures could be poor risk measures, or the duration matching strategy is not the most appropriate immunization approach when there is high volatility because yield curve shifts would often be large.; Under the active portfolio management criterion and with the duration and convexity matching strategy, the immunization performance of traditional risk measures improves considerably at the high volatility segments of the yield curve. The improvement in the performance of the HJM risk measures is not as dramatic. The immunization performance of traditional duration and convexity measures, however, deteriorates at the low volatility segments of the yield curve. This deterioration is not observed when HJM risk measures are used. Overall, with the duration and convexity matching strategy, the immunization performance of portfolios matched with traditional risk measures is very close to that of portfolios matched with the HJM risk measures. This result suggests that the duration and convexity matching approach should be preferred to duration matching alone. Also the result shows that the underperformance of traditional risk measures under high volatility is not due to their being poor risk measures, but rather due to the reason that the duration matching strategy is not an appropriate immunization approach when there is high volatility in the market.; Under the passive portfolio management criteria, the performances of traditional and HJM measures are similar with the duration matching strategy. Less than 29% of the duration matched portfolios have returns within one basis point of the target yield, whereas almost all are within 00 basis points of the target yield. These results suggest that the duration matching strategy might not be sufficient to generate cash flows close to those of the target bond. The duration measure assumes a linear relation between the bond price and the yield change, and the nonlinearities that are not captured by the duration measure might be importan...