LIABILITY-DRIVEN AND INDEX-BASED STRATEGIES

Question 1

Explain how we can know if a portfolio FV will be able to fund the liability

Answer 1

The IRR (internal rate of return) will indicate if we will have sufficient FV to fund the Liability. We have to be careful not to get confuse with average YTM.

Question 2

Explain the concept of a zero replication strategy

Answer 2

To immunize a single liability, we can refer our strategy to the fact that a zero coupon bond, with the same maturity and same par value.

Question 3

Identify the rules for immunizing a single liability

Answer 3

1. Initial PVA have to be equal (or greater) than the PVL.
2. Portfolio Macaulay duration has to be equal to the due date of the liability payment.
3. Convexity has to be minimize (minimize the dispersion of cashflow around the liability)
4. Regularly rebalance the portfolio to maintain the duration match as time and yield change

Question 4

Whats the formula to calculate the basis point value (BPV)

Answer 4

BPV = MD * Value * 0.0001

Question 5

Identify the rules for immunizing multiple liabilities

Answer 5

1. Initial PVA has to be equal (or greater than PVL)
2. Money duration of the portfolio has to matched the money duration of the assets
3. Convexity of the assets has to be slightly higher than liabilities.
4. Rebalance the assets regularly to maintain the BPV match of Assets and liabilities as yield and time change.

Question 6

Formula to calculate the BPV of futures contract

Answer 6

BPV Futures = BPV CTD / CF CTD

Question 7

Whats the formula to calculate the number of contract needed to adjust the portfolio assets

Answer 7

of futures contracts = BPV liabilities - BPV Portfolio / BPV futures

Question 8

When a manager is hedging a liability with Treasurary Bonds contract and expect that the interest rate will decrease, explain what should he do if he has the possibility to over/under hedge.

Answer 8

To profit by this, he will buy more contracts than required for a 100% hedge to set the asset duration above the liability duration

Question 9

Whats the formula to calculate the notional principal of an interest rate swap to hedge a position

Answer 9

NP = Duration gap / (BPV of net swap/100)

Question 10

If a manager enters a receiver swaption, explain the process and how can the manager profit on it

Answer 10

Receiver swaption = manager has the right but not the obligation to enter a receiving swaption – he has to pay an initial premium for it. The strike price is called the swap fixed rate. If at some point in time, the SFR is lower than the one taken by the manager at first, this right to receive a now above-market SFR has positive value and effectively increases the BPV of the assets.

Question 11

Consider the DB plan with a duration gap and a need to increase asset duration. What are the swap-based hedging options that the managers has to reduce interest rate risk.

Answer 11

1. Buy a receive fixed swaps againts MRR
2. Buy a receiver swaptions
3. Enter a zero-collar swaption, you buy a received fixed swaptions and you sell a pay fixed swaptions.

Question 12

Explain risks associated with managing a portfolio againts a liability structure

Answer 12

1. hedge amount are approximations based on durations and ignore convexity.
2. Duration assume parallel shifts in curve and ignores structural risk.
3. We can have measurement errors when weighted average characteristics of the portfolio assets and liabilities are used instead of statistical approach.
4. Futures BPV calculation are based using CTD bond. That bond can change, changing the futures duration and BPV.
5. Portfolio yield and liability discount may differ. This creates spread risk.
6. Assets liquidity risk. if position cannot be adjusted at reasonable cost.
7. OTC create counterparty risk. With the move towards requiring collateral reduces counterparty risk, it now creates a cashflow risk. Counterparties must be prepared to meet those cash demands.

Question 13

Contrast pure index/full replication with enhanced indexing portfolio

Answer 13

Pure index/full replication : Holding all the securities of the benchmark and having the same weight as the benchmark.

Enhanced indexing : Having the same primary characteristics as the benchmark but without having to hold the same exact holdings.

Question 14

Identify which type of characteristics to match with the benchmark when constructing an enhanced indexing portfolio.

Answer 14

1. Matching Modified Duration (Effective duration for bonds with embedded options)
2. Matching Key rates duration
3. Match weighting of the different sector and credit ratings exposure
4. Match sector/coupon/maturity weights of the index.
5. Matching issuer exposure weight to control for specific event risk affecting that issuer only.

Question 15

Identify the alternative methods for establishing a bond market exposure passively

Answer 15

1. Bond index mutual funds
2. Open-ended fund
3. ETF
4. Total-return Swap

Question 16

Explain the Credit Barbell custom benchmark strategy

Answer 16

A manager could create a custom benchmark which contains for exemple, 50% long term treasuries (with no interest or spread risk) and 50% short term corporate bonds to add spread returns.