Introduction

The continuously increasing competitiveness and complexity of the fixed-income markets have been a driving force in the use of sophisticated quantitative techniques in financial planning applications.

Not long ago, investors purchased securities or portfolios of securities with the implicit assumption that the securities would be held to maturity and that interest rates would remain stable. In this environment, investment decisions were based primarily on credit quality and yield-to-maturity. To a large extent, interest-rate risk was disregarded. As a result, when rates rose dramatically in the late 1970s and early 1980s, investors were faced with immense interest-rate risk exposure. In response, immunization techniques, such as cashflow matching, duration matching, and portfolio insurance, were developed and were proved to be sufficient.

However, the dramatic growth of the mortgage sector, the introduction of sophisticated new securities and hedging instruments, and increasing interest-rate volatility have forced portfolio managers to develop more complex mathematical techniques that are capable of addressing long-term investment concerns under a variety of interest-rate environments.

Traditional portfolio-management techniques do not provide an efficient solution to the problems associated with actively managing a portfolio in the current market environment. Portfolios that are simply duration-matched cannot achieve the desired tradeoff between risk and reward in volatile environments. Conventional investment parameters, such as yield-to-maturity, duration, and convexity, are insufficient to evaluate a portfolio adequately.