Portfolio Management Strategies 12- Liability Driven Investing for

Question 1

What does a aliability-driven investing (LDI)
approach focus on?

Answer 1

It focuses on managing plan assets in a way that best meets the present and future values of liabilities

Question 2

What is the equation of an LDI portfolio?

Answer 2

Market Value of Plan Assets – Present Value of Plan Liabilities = Funding Status

Question 3

What is the definition of market value of plan assets?

Answer 3

it is the value of a company according to the stock market

Question 4

What is the definition of present value of plan liabilities?

Answer 4

It is an estimation of future liability at a discounted rate

Question 5

What is a funding status?

Answer 5

It is a residual of all asset and liability interactions, as the relevant “portfolio” to be managed

Question 6

What are risk factors that the LDI approach reduces?

Answer 6

quity risk, interest-rate risk, credit-risk spread, inflation risk, yield curve slope risk, and a range of factors affecting security performance

Question 7

What is a funding ratio?

Answer 7

It reflects a pension fund’s current financial position, expressing the ratio between available assets and liabilities

Question 8

What are two important indicators of how well a plan is managed?

Answer 8

low surplus volatility and an increase in the funding ratio

Question 9

Why are these two indicators important?

Answer 9

Long-run returns with high short-term volatility result in short-run contributions to the plan that are not recoverable later when the return performance recovers

Question 10

Do lower interest rates make the present value of liabilities

higher?

Answer 10

yes, because the discount rate is an important factor in the present value of outflows calculation. A combination of underfunding and investments in securities that fall in value when interest rates fall make the plan performance riskier.

Question 11

Why is the funding ratio important?

Answer 11

The risks in the liabilities play a larger role in an unfunded status

Question 12

Why is the funding ratio important?

Answer 12

The risks in the liabilities play a larger role in an unfunded status

Question 13

To offset the recent (and expected) modest performance
of stocks and bonds, planned assets must _______.

Answer 13

include a wider array of securities, since plan returns and volatility from stock and bond contributions are not sufficient to improve funding ratios

Question 14

Real assets tend to be _______ to inflation
because of their tangible nature.

(sensitive or insensitve)

Answer 14

sensitive

Question 15

What are examples of real assets?

Answer 15

• direct investment in real estate
• commodities
• precious metals
• timber
• energy
• farm-land
• commodity-linked stocks
• commodity-linked hedge funds

Question 16

What do real assets do for an LDI platform?

Answer 16

They provide potential reductions in surplus volatility to the extent that real asset movements are not highly correlated tomovements of financial assets.

Question 17

What does inflation do for an LDI platform?

Answer 17

Real assets generally appreciate with inflation while inflation
directly drives interest rates higher and financial assets lower. Returns from real assets also may boost returns, because
real assets may not be as efficiently priced as the more competitively priced stocks and bonds.

Question 18

Why are real assets considered attractive?

Answer 18

There tends to be much less diversification potential from combining assets within an asset class than from combining assets from different asset classes.Real assets represent such a broad asset class that a wide range of correlations exists both within the asset class and with assets from other asset classes, allowing for attractive diversification.

Question 19

What is an asset class?

Answer 19

A group of assets that have high correlations with each other but have low correlations with other groups of assets

Question 20

What is a dynamic approach?

Answer 20

It varies the size and composition of hedge assets in response to economic and market factors in an effort to improve outcomes

Question 21

Correlations ____ stable in the short run and surplus volatility must be actiively managed with prompt and pre-planned responses.

(are or are not

Answer 21

are not

Question 22

What are the two views investors behave like?

Answer 22

Rational view and behavioral view

Question 23

What is a rational view?

Answer 23

It focuses on maximizing wealtg and is low risk-taking
- hold well diversified “efficient” portfolios
- incorporate all available information
- only “fundamentals” matter

Question 24

What is a behavioral (psychogiy) view?

Answer 24

• individuals suffer from biases and misperceptions
• don’t always incorporate relevant information
• sometimes base decisions on “non-fundamental” emotions

Question 25

What is behavioral finance?

Answer 25

it attempts to ecplain financial market behavior using results from experimental psychology- how market prices are effected when investors do not behave “rationally”

Question 26

What does the efficient market hypothesis (EMH) explain?

Answer 26

It doesn’t say that all investors are rational. It says

Question 27

What does market efficiency mean?

Answer 27

security prices are right meaning they fully reflect all available information

Question 28

What does “there is no free lunch” explain?

Answer 28

• the only way you can get higher retuirns is by taking on more risk
• there is no information out there that can be used to construct strategies that earn returns higher than required for their risk

Question 29

What is a joint hypothesis problem?

Answer 29

Any rejection of a model of the risk premium and market efficiency means

Question 30

LDI takes into account the need to fund future liabilities and make sense if future liabilities are _______________.

Answer 30

predictable.

Question 31

Examples of liability-driven investors:

Answer 31

Defined benefit pension fund
Insurance company
AN individual retiree