ALM Pension Funds and Credit Risk Flashcards
What is Asset-Liability Management?
ALM is the practice of managing assets and liabilities to minimize financial risk and ensure the solvency of pension funds and insurers.
Why is ALM important for pension funds?
Pension funds have long-term liabilities (future payouts), which are sensitive to interest rates. If interest rates fall, the present value of liabilities rises, making the fund underfunded. ALM ensures assets grow in a way that covers liabilities.
What is the Funding Ratio? Why does it matter?
Funding Ratio = Assets / Liabilities
If FR > 100% is overfunded and vice versa.
If a fund has 1.2B in assets and 1B in liabilities, its FR = 120%, meaning it has an extra cushion.
What is Net Duration and why does it matter?
D = Dl - (B/L * Db)
If Net Duration > 0, the fund is exposed to falling interest rates.
If Net Duration = 0, the fund is immunized from rate changes.
Pension fund liabilities have long duration, while their assets have shorter duration. This duration gap causes problems when interest rates changes.
How do we calculate the PV of liabilities?
Take the present value of all future cash flows with their respective discount factors.
Lower interest rates - higher value of liabilities.
If a pension fund expects to pay $10M per year for 30 years, the total liability is not $300M, but much lower because future payments are discounted.
How do interest rate changes affect liabilities?
Change in Liabilities = -Dl * DeltaR
If interest rates drop 1%, liabilities increase with Dl * 1%.
How do pension funds hedge against interest rate risk?
Long-term bonds, which increase asset duration (hard to find however)
Interest rate swaps, use receiver swaps to receive fixed and pay floating to match liability sensitivity.
Swaptions - buy receiver swaptions to profit when rates fall (without locking in low rates)
What is the formula for hedging duration risk using swaps?
Dl - (B/L * Db) + N/L * Ds = 0
Find N by rearranging.
What are the biggest liquidity risks when using swaps?
Margin calls, if interest rates rise, the pension fund must post collateral, which can drain liquidity and cash reserves.
Market volatility, if a crisis occurs, swaps become expensive to roll over.
Fire sales, if the fund lacks cash, it may have to sell assets at discount.
What is credit risk?
Risk that a borrower fails to meet its obligations. It affects bonds, loans, and derivatives.
How do we measure credit risk?
Credit ratings, issued by Moody’s, S&P, Fitch etc.
Credit Spreads, Higher Spread = Higher Risk.
Merton’s Model, it treats company equity as call option on assets.
What is a credit default swap?
A financial contract that provides insurance against default. Protection buyer pays a premium; protection seller pays in case of default. It’s like insurance on a bond - if the bond defaults, the CDS seller pays compensation.
How is the CDS payout calculated?
CDS payoff = (1 - R) * Notional Amount
If a bond defaults, the CDS covers the loss after recovery.
How do we estimate default probability using a CDS spread?
Lambda (Hazard Rate) = Spread / (1 - Recovery Rate)
Implied Default Probability = Q(t) = 1 - e^-t*Lambda
CDS spreads reveal what the market expects for default risk.
