Equity Duration and Portfolio Risk Management

Abstract

The authors adopt the perspective of a portfolio manager simultaneously holding long and short equity positions and investigate whether portfolio standard deviation is reduced by calibrating the overall portfolio duration to be zero. Although numerous studies have suggested that equity duration may be useful in portfolio risk management, this study directly tests this proposition. The authors first identify some methodological issues involved with measuring equity duration and then explore the use of equity duration as a tool in portfolio risk management. They present strong evidence that equity duration can be used in equity portfolios to reduce volatility and introduce a novel test that involves the comparison of market-neutral portfolios that are duration hedged with those that are duration exposed. Portfolio standard deviations form a “volatility smile” that reaches a minimum when duration is fully hedged. The results suggest that duration may be measuring risk not captured by beta.