Introduction

Abstract

The tools of modern portfolio theory are in general use in the equity markets, either in the form of portfolio optimization software or as an accepted frame-work in which the asset managers think about stock selection. In the fixed income market on the other hand, these tools seem irrelevant or inapplicable. Bond portfolios are nowadays mainly managed by a comparison of portfolio risk measures vis á vis a benchmark. The portfolio manager’s views about the future evolution of the term structure of interest rates translate themselves directly into a positioning relative to his benchmark, taking the risks of these deviations from the benchmark into account only in a very crude fashion, i.e. without really quantifying them probabilistically. This is quite surprising since sophisticated models for the evolution of interest rates are commonly used for interest rate derivatives pricing and the derivation of fixed income risk measures.