the promised coupon payments and eventually par value at maturity. A bond that is believed to have a high probability of maturing at par can trade at a premium to par value, but it is very rare that a bond will trade well above, say, 120 percent; and even if it does it is likely due to duration risk (i.e., a long-duration bond rallies a lot after interest rates fall significantly), not security-specific risk. Conversely, if a bond defaults or the market assigns a high probability to default, the market price can go below 50 percent of par value. Due to this asymmetric payoff of fixed income securities, it is very important to maintain proper diversification in bond portfolios that are exposed to any meaningful amount of credit risk. The measure typically used for security-specific risk is either contribution to duration (CTD) for securities in low-risk sectors like governments and MBSs or market value percentage for riskier securities such as corporate bonds and emerging-market debt (EMD). As you can see, the types of risks that a fixed income portfolio manager needs to be aware of are many and quite varied. Understanding what risks are in a bond portfolio and what the potential impacts of these exposures are is critical to being able to build portfolios that are consistent with the investor's risk and return objectives. FIXED INCOME BENCHMARKS Generally speaking, the choice of benchmark is the most important factor in determining the risk profile and the ultimate returns of a fixed income portfolio. Since, as we will discuss later, it is somewhat difficult to achieve very high levels of tracking error relative to a fixed income benchmark, the risk of even an actively managed portfolio will be mostly determined by the risk of the benchmark. Of the risks that were described in the previous section, the four risk exposures that define most fixed income benchmarks are duration, sector, credit, and currency risks. The remaining risks mentioned (yield curve, volatility, prepayment, and security-specific) are generally a result of the decision on the first four since most fixed income benchmarks are constructed using market capitalization weights of the securities in the sectors and maturity ranges that have been chosen to achieve the desired duration, credit quality, and sector allocation. Table 24.3 shows a list of some of the more widely used benchmarks in the fixed income world. As you can see, the types of fixed income benchmarks are wide-ranging and span the entire spectrum of fixed income risks that we have described. Another important item to note is that with the exception of benchmarks with mostly below-investment-grade credit quality, the main determinant of fixed income volatility is interest rate risk. Also, diversifying interest rate risk globally reduces volatility, while adding currency risk (i.e., using an unhedged currency benchmark) increases volatility. Of course, many investors construct their own customized benchmark indexes by combining all or portions of some of the more widely used benchmarks. This allows them to tailor their benchmarks (and the portfolios that are managed to those benchmarks) to have the desired types and amounts of risk. For example, an investor who wanted a Treasury benchmark but wanted a duration of one year could create a customized benchmark that was equal to 50 percent of the Merrill Lynch