Volume 3 — Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 25 7.0 Tenor Metrics One of the important dimensions of value and risk is the element of time. By this, we mean the decomposition or bucketing of either the value or the risk of any portfolio of positions or an economic stream of benefits/costs into appropriate time periods when the value, benefit, cost, or the variability around the value, benefit, or cost is expected to occur. The tenor metric discussed below achieves an optimal structure for measuring value and risk along this dimension and can be used to provide pertinent information on performance and risk to various stakeholders. 7.1 Discussion of Metric Given that significant portions of the projected and reported revenues are based on MTM and as yet unrealized values where the streams of revenues and costs are likely to occur at different points in the future, stakeholders want to understand the quality of this revenue and cost stream, the timing of the revenues, and potential variability of the revenues and costs. Whereas a market risk estimate (typically the VaR of the portfolio/activity under consideration) gives a measure of the potential variability and the credit exposure estimate represents the potential counterparty risk, the quality and the relative timing of the revenue and cost streams can be captured by a metric that simultaneously takes into account the level and the timing of the different costs and revenue estimates or expected values. This metric is called the average tenor of the MTM portfolio/activity, which is a value-weighted estimate of the average length or tenor of the portfolio or activity. There are certain subtleties one must keep in mind when calculating such a metric. To help understand this, we refer to the concept of duration that is widely employed in the financial markets to examine the characteristics of a portfolio of assets and liabilities that is sensitive to interest rate movements. When a portfolio of positions has both positive and negative values occurring at different periods in time, a value-weighted tenor metric does not convey any rational and economically useful information. It is therefore the approach in the financial markets to compute two sets of durations, one for the portfolio of assets (positive values) and another for liabilities (negative values). We develop a similar approach for the value-based (or weighted) tenor metric in Appendix E. Such a value-based tenor measure for a trading/marketing portfolio or activity can be used to assess the quality of the expected revenues/costs. A short tenor would generally stand for a higher quality portfolio than a long tenor since the potential for variability is that much greater in the latter and a greater portion of the value is captured early. However, one must be very careful in trying to infer more than value-based information from such a metric. It is possible to have a lower risk portfolio where the values are captured over a longer time period as contrasted with a higher risk portfolio where the values are recovered over a shorter time horizon. It would therefore be a mistake to conclude from a simple examination of the tenor values reported that the second portfolio represents a higher quality of value as contrasted with the first, when in fact the reverse is true. Below are the essential elements of the calculation that can be used for arriving at a value- weighted tenor. With the caveat stated above, one should categorize the expected values into