The problem with this is that you get whatever giant risks you aren’t measuring properly. That’s what happened at SVB, they bought tons of ‘safe’ assets while taking on a giant unsafe bet on interest rates because the system didn’t check for that. Also they cheated on the accounting, because the system allowed that too.
A very good example of Goodhart’s Law/misalignment. Highlighting for the skimmers. Thanks for the write up Zvi!
Tidbit to make this comment useful: “duration” is the (negative) derivative of price with respect to yield—a bond with duration of 10 will be worth 5% (relative to par) after a 50 bip (0.5%) rate hike. So why do they call it duration? Well, suppose you buy a 10 year bond that pays 2% interest, and then tomorrow someone offers you a 3% 10 year bond. How much money do you have to pay to trade in yesterday’s bond? Well, pretty much you have to pay an extra 1% for each year of the bonds life!
This is probably dead obvious to everyone in finance, but I only got into finance by joining fintech as after a math undergrad, and it took me years to figure out why they called it duration when they are nice enough to call the second derivative “convexity”.
A very good example of Goodhart’s Law/misalignment. Highlighting for the skimmers. Thanks for the write up Zvi!
Tidbit to make this comment useful: “duration” is the (negative) derivative of price with respect to yield—a bond with duration of 10 will be worth 5% (relative to par) after a 50 bip (0.5%) rate hike. So why do they call it duration? Well, suppose you buy a 10 year bond that pays 2% interest, and then tomorrow someone offers you a 3% 10 year bond. How much money do you have to pay to trade in yesterday’s bond? Well, pretty much you have to pay an extra 1% for each year of the bonds life!
This is probably dead obvious to everyone in finance, but I only got into finance by joining fintech as after a math undergrad, and it took me years to figure out why they called it duration when they are nice enough to call the second derivative “convexity”.