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johncheng
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Joined: October 25th, 2021, 4:55 pm

Parallel Interest Rate Shocks (shock before boot strapping or after?)

October 27th, 2021, 12:13 am

I'm looking to create interest rate shocks (parallel (25/50/75 bps up/down), non parallel (steepener/flattener) on a fixed income portfolio. Should I be shocking the market instruments before bootstrapping or shocking the zero curve after bootstrapping? This would apply to both swap curves (eg. USD 3M LIBOR) as well as government (eg. US treasury).

I think the answer is to shock the zero curve after bootstrapping - If someone could explain why - that'd be much appreciated. Thanks!
 
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bearish
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Re: Parallel Interest Rate Shocks (shock before boot strapping or after?)

October 28th, 2021, 3:26 am

I think, strictly speaking, if you do a proper bootstrap it doesn’t really matter. However, if you do anything that “smooths” the yield curve, then you definitely want to shock the post-fitted version. Otherwise, you run the risk of smoothing away parts of your curve shocks. Although that is a bigger problem for key rate shocks than for parallel shocks. So you may be good either way.
 
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DavidJN
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Joined: July 14th, 2002, 3:00 am

Re: Parallel Interest Rate Shocks (shock before boot strapping or after?)

October 28th, 2021, 7:59 pm

Depends on your perspective. Traders typically shock the par curve because those are the instruments you trade in to hedge your positions. Risk managers and academics sometimes shift the post-bootstrap zero curve because it is theoretically clean and elegant. One cannot, however, practically trade zeroes to hedge a swap product book because of liquidity and pricing issues Either the par or zero curve (or even the forward curve too) can be used for this work due the arb-free consistency of the bootstrap algorithm. Given one of the curves you can derive the other two.  

Having said this, I heartily concur with bearish's observation about being careful when using smoothing tactics. Art (judgement, really) is used in curve building as well as science. It would be a great exercise for students to build and compare calculating sensitivities using the three curves mentioned (par, zero and forward) and see what kinds of issues (e.g. smoothing) cause them to disagree and to what extent.         
 
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bearish
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Re: Parallel Interest Rate Shocks (shock before boot strapping or after?)

October 28th, 2021, 11:41 pm

Right - there is a distinct benefit to get sensitivities in terms of things you can actually trade. This may be the time to discourage the use of parallel shocks, because they usually aren’t. Like, say, this week. At least in USD.
 
johncheng
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Joined: October 25th, 2021, 4:55 pm

Re: Parallel Interest Rate Shocks (shock before boot strapping or after?)

November 1st, 2021, 5:13 pm

Thanks Everyone - All arguments make a lot of sense!