Liability-Driven and Index based strategies

Question 1

Elaborate on ALM

Answer 1

LDI: Liability driven investing
ADL: Asset driven liability

Question 2

How can you manage the interest rate risk of a single liability?

Answer 2

An investor having an investment horizon equal to the bond Macaulay durations effectively protected or immunize against rate risk in that price and coupon reinvestment effect offset each other.

Question 3

Compute convexity

Answer 3

Convexity = (Macaulay duration^2 + Macaulay duration + Dispersion) / (1+ yield)^2

Question 4

What is structural risk ?

Answer 4

The structural risk is the risk that non-parallel shifts lead to changes in a the CF yield that does not match the YTM of the zero coupon bond that provides perfect immunization. Structural risk can be reduced by minimizing the dispersion of the bond portfolio that concentrates the component bonds’ duration around the investment horizon.

Question 5

What are the Characteristics of a bond portfolio structured to immunize a single liability ?

Answer 5

• Should have an initial market value that equals or exceed the present value of the liability.
• Should have a Macaulay duration that matches the liability due date
• Should minimize the portfolio convexity but is above that of the liability.

The portfolio must be therefore rebalanced over time to maintain the target duration, because the target Macaulay duration changes as time passes and yield changes.

Question 6

Elaborate on convexity

Answer 6

Convexity is generally a good aspect of a bond which improves gain further as yield fall and reduces losses as rates rises.

Question 7

Wat is the motivation for CF-matching ?

Answer 7

+Accounting defeasance is a way of extinguishing a debt obligation by setting aside sufficient high quality security such as treasury notes to repay the liabilities.

Question 8

What is a duration matching ?

Answer 8

A portfolio structured and managed to lock and track the performance of a zero-coupon bond that would offer a perfect immunization.

For single liability, the point is to match the duration with the investment horizon.

Question 9

Compute Modified duration

Answer 9

= Macaulay duration / (1+yield)

Question 10

Compute Money duration

Answer 10

= Modified duration * Bond value

Question 11

Elaborate on duration matching when assets and liability differ ?

Answer 11

When assets and liabilities differ, duration matching entails matching the money duration of both sides.

Question 12

Elaborate on duration overlay

Answer 12

Asset portfolio BPV + (Nf Futures BPV) = Liability portfolio BPV

Nf = (Liability portfolio BPV - Asset portfolio BPV)/Futures BPV

If Nf is positive, then buy futures contact if negative hen sell future contract

Future BPV = BPV ctd/ conversion factor

Question 13

What is contingent immunization ?

Answer 13

Whenever there is a surplus between the immunized asset portfolio and the liabilities, the asset manager may consider a hybrid passive-active whereby the portfolio is actively managed as long as there a surplus. The objective is to underhedged when yield are expected to rise and over-hedged when rates are expected to fall.

Question 14

How to address duration gap between liabilities and assets ?

Answer 14

This can be addressed with futures contracts. However large exposure in future can lead to significant daily cash inflow and outflows. For that reason, hedging problems are addressed with swaps.

Asset BPV = (NP * Swap BPV/100) = Liability BPV

An alternative could be the Swaption or option on swap.

Question 15

Risk decomposition

Answer 15

(Assets BPV * change in Assets Yield) + (Hedge BPV * change in Hedge yield) = Liability BPV * change liability Yield)

Question 16

What is the advantage of hedging corporate bond with swap ?

Answer 16

They pose less spread risk than futures or treasury.

Question 17

What are the alternatives to investing directly in bonds ?

Answer 17

• Mutual funds
• ETF
• Index based on total return swap

That said some considerations should be taken into account when using swap, the investor is not legally the owner and the swaps have short lengths.

Question 18

What is a laddered bond portfolio method ?

Answer 18

Laddered bond portfolio method consists in evenly spreading the bond maturity along the yield curve. An advantage of laddered portfolio is the protection from shifts and twists. Moreover, it has less reinvestment risk. The diversification over time provides investors a balanced position between the two sources of interest rate risk:

Interest rate risk= Cf reinvestment + Mkt price vola

If the portfolio consists of a limited number f corporate bond, pls consider using a mutual fund.

Question 19

What is a bullet bond portfolio method ?

Answer 19

Bullet bond portfolio method concentrates the bond at a particular point on the yield curve. It has the lowest convexity

Question 20

What is a barbell bond portfolio method ?

Answer 20

Barbell bond portfolio method places the bonds at the short term and long term end of the yield curve. The barbell has the highest convexity.

Question 21

Elaborate Received-fixed interest rate swaps.

Answer 21

Received-fixed interest rate swaps gains value as current swap market rates falls. Raise the hedge ratio when rates are anticipated to rise. An alternative would be to pay for a receiver swaption

Question 22

Elaborate on rates movements

Answer 22

Rate to fall —–> receiver-fixed swap

Rate to rise ——> swaption collar

Question 23

How to minimize structural risk ?

Answer 23

Structural risk can be minimize by reducing dispersion and convexity of the bond, going from a barbell to a bullet structured concentrated toward to liability horizon.

Question 24

What is a model risk

Answer 24

A model risk is the risk that the assumptions made about the future events or parameters are wrong.

Question 25

What type of portfolio is more suited for a companies with a young working force ?

Answer 25

Go for a portfolio with long duration which is not market cap weighted to avoid bums problems.