Liability-Driven and Index-Based Strategies Flashcards
Liability-Driven Investing
(1) the future liabilities are defined
(2) the assets are managed to meet those future liability values
Asset-driven liabilities
(1) the asset are given
(2) the liabilities are managed/adjust in relation to those assets
type of liabilities
+ Type I: know amount - know time: option-free fixed rate bond
+ Type II: know amount - unknow time: life insurance, callable, putable bond
+ Type III: unknown amount - know time: Floating rate note, TIPS.
+ Type IV: unknown amount - unknown time: property & casual insurance, DB
immunization
+ process of
+ structuring and managing a fixed-income bond portfolio
+ to minimize the variance in the realized rate of return (cash flow yield)
+ over a known time horizon
portfolio dispersion
is often interpreted as a measure of the degree of uncertainty, and thus risk, associated with a particular security or investment portfolio.
zero replication
set up the portfolio with the same Macaulay duration, and then continually update it in order to keep it matched
Exhibit 7 - 294
structural risk
The risk is that yield curve twists and non-parallel shifts lead to changes in the cash flow yield that do not match the yield to maturity of the zerocoupon bond that provides for perfect immunization.
bond portfolio structure to immunize a single liability
+ initial MV of assets >= MV of liabilities
+ portfolio Macaulay Du match liability’s due date
+ minimized portfolio convexity statistic
managing interest rate risk
+ CF matching
+ Duration matching
+ Contingent immunization
accounting defesance / in-substance defeseance
extinguishing a debt obligation by setting aside sufficient high-quality securities, such as US Treasury notes, to repay the liability
(Bỏ nghĩa vụ nợ thông qua nắm giữ TP chất lượng tốt)
Derivative overlay / Future contracts
use future contract to close duration gap while keep the underlying portfolio unchanged
contingent immunization
is a hybrid active/passive strategy and requires a significant surplus
As long as that surplus is of sufficient size, the portfolio can be actively managed
At the extreme, assets could be invested in equity, commodities, real estate,…
(1) If the assets earn more than the initially available immunization rate, the surplus will grow, and can eventually be returned to the investor.
(2) If the strategy is unsuccessful, the surplus will shrink, and the portfolio must be immunized before the surplus declines below zero
Swaption Collar
= long receiver swaption + short payer swaption
Full Replication
An approach that purchase all securities in the index
Unwind
is a process of reversing or closing a trade by participating in an offsetting transaction
POD approximation
≈ Spread/LGD and LGD = (1 − RR)
yield spread
= bond’s YTM - the YTM of an on-the-run government bond of similar
maturity
+ Other name: benchmark spread
G-spread
= yield of Bond - interpolation of gov
ASW
= bond’s fixed coupon - maturity interpolate SFR
I-spread
= bond’s YTM - maturity interpolate asset swap rate
QM
(1) Definition: yield spread over MRR of original FRN
(2) Advantages: Represents periodic spread related FRN cash flow
(3) Disadvantages: Does not capture changes in credit risk over time
Discount margin
(1) Definition: Yield spread over MRR to price FRN at par
(2) Advantages: Establishes spread difference from QM with constant MRR
(3) Disadvantages: Assumes a flat MRR zero curve
Discount margin
(1) Definition: Yield spread over MRR to price FRN at par
(2) Advantages: Establishes spread difference from QM with constant MRR
(3) Disadvantages: Assumes a flat MRR zero curve
Z-DM
(1) Definition: yield spread over MRR curve
(2) Advantage: Incorporates forward MRR rates in yield spread measure
(3) Disadvantage: More complex calculation and yield spread does not match FRN cash flows
Function of excess spread no defaults
ExcessSpread ≈ Spread0 − (EffSpreadDur × ΔSpread)
Function of excess spread with default
Spread0 − (EffSpreadDur × ΔSpread) − (POD × LGD)
Spread0: include period
POD: sometime annualize
Asset-liability management
strategies that consider assets in relation to liabilities. It is appropriate when both the present value (PV) of the assets and liabilities change with changing interest rates.
3 Rules for immunizing a single liability
(1) Initial portfolio market value (PVA) equals (or exceeds) PVL.
(2) Portfolio Macaulay duration matches the due date of the liability (DA = DL)
(3) Minimize portfolio convexity
compare laddered bond portfolio to other in diversified between price and reinvestment risk
Laddered portfolio is higher
compare laddered portfolio to barbell in reinvestment risk
laddered bond portfolio is less reinvestment risk
compare laddered portfolio to bullet in convexity
laddered bond portfolio is greater convexity
tool to adjust duration gap
(1) Treasury bond contracts
(2) Interest rate swaps
(3) Swaption
money Duration
= Dollar Duration
(1) the price change in units of the currency in which
the bond is denominated
(2) = BPV / 0.0001
(3) = ModDur x PV
(4) Meaning: to serve immunize portfolio
Portfolio dispersion
= [(t-MacDur)^2] X Weight
Disadvantage of immunization
ignore convexity
The conditions to immunize multiple liabilities
(1) the market value of assets is greater than or equal to the market value of the liabilities,
(2) the asset basis point value (BPV) equals the liability BPV, and
(3) the dispersion of cash flows and the convexity of assets are greater than those of the liabilities.
advantages of ladder portfolio
(1) High credit quality
(2) Liquidity
(3) Yield curve diversification
2 method in derrivatives overlay
(1) using future
(2) using swap
What is social responsible investing
is ESG
spread risk/ basis risk
+ the risk that a bond’s price will change in response to an idiosyncratic rate move rather than an overall market yield change is known
+ = MV asset - MV derivative to hedge it
what kind of duration to model Type I, Type II, Type III, Type IV
Type I: Modified Duration
Type II, III, IV: Effective Duration
which expose rollover risk
(1) ETF
(2) Mutual fund
(3) Total return swap
(3) total return swap
relationship of CF dispersion and convexity
For portfolios with the same Macaulay duration and cash flow yield: the portfolio with the greatest dispersion of cash flows will have the highest convexity
collateral exhausted risk
the risk that the manager has no anymore assets to collaterized
how to expose: short payer swaption
ABO (definition) and PBO (definition)
- ABO
+ accumulated benefit obligation
+ calculates the liability of Pension plan
+ based on the G years worked and the current annual wage - PBO:
+ projected benefit obligation
+ measure uses the projected wage for year T instead of the current wage
why treasury bond volatile than HY corp bond ?
Treasury bond is more volatile because:
+ Is being trading more
+ HY corp bond include spread + risk free interest -> sometime fluctuate not the same side -> less volatile than treasury bond
ABO (accumulated benefit obligation)
The ABO calculates the liability based on the G years worked and the current annual wage
PBO (projected benefit obligation)
Tính giống ABO, nhưng dựa trên projected wage
