QFIP-141: Liability Driven Investment Explained

Question 1

List two main risks of pension liabilities

Answer 1

1. Interest rate risk
   Ÿ Lower interest rates increase the present value of a scheme’s liabilities
2. Inflation risk
   Ÿ Higher inflation will increase future liability cashflows, thus increasing the present
   value of the pension liability

Question 2

Describe two main disadvantages of using bonds to hedge interest rate and inflation
risk of pension liabilities

Answer 2

1. There is a scarcity of long-dated bond assets available for pension schemes to
   use to hedge against their liabilities
2. In order to buy bonds, a pension scheme needs to raise cash by selling out of
   growth assets (i.e. equities, property)

Question 3

Describe different swaps that a pension scheme can use to hedge liability risk

Answer 3

1. Interest rate swaps
   Ÿ Pension scheme typically enters into a swap where it will receive fixed interest, and
   pay a floating interest that is linked to a 3M Libor rate
2. Inflation swaps
   Ÿ Pension scheme typically enters into a swap where it will receive a floating rate that
   is linked to inflation, and pays a fixed rate
3. Real rate swaps
   Ÿ Combines the hedging of interest rate and inflation into one contract

Question 4

What are the main advantages of using interest rate swaps and derivatives for hedging
interest rate and inflation risk?

Answer 4

The main advantage of using swaps and other derivatives to hedge interest rate and
inflation risk is it is capital efficient

Swaps are entered at zero value, so pension schemes can enter into swaps
without requiring any initial investment

Thus, swaps are a nice alternative to bonds for managing risk because they don’t
require the pension scheme to sacrifice investing more money in growth assets
such as equity

Question 5

Describe derivatives one can use to gain exposure to a risk-free bond without
purchasing the physical instrument

Answer 5

1. Total return swap (TRS)
   Ÿ Pension scheme will pay a floating rate (i.e. LIBOR +/- spread), and in exchange will
   receive the total return of the bond
2. Repurchase agreements
   Ÿ Pension scheme borrows money from a bank using a bond they already own as
   collateral
   Ÿ The borrowed money can then be used to buy more bonds
3. Futures contract
   Ÿ Enter into an agreement to buy or sell the bond at a fixed price in the future

Question 6

How can a pension scheme still obtain equity exposure if 100% of its capital is invested
in bonds?

Answer 6

A pension scheme can also replicate passive equity exposure using derivatives and no
capital investment
1. Sell off all equities and invest 100% of its capital in bonds
2. Replicate its prior equity exposure by entering into equity futures contracts or total
return swaps

Question 7

Describe some practical considerations of managing LDI portfolios

Answer 7

1. Minimizing dealings costs with a bank
   Ÿ The costs of entering into financial derivatives (swaps, futures) with a bank will be
   lower if the bank can easily find the opposite of the trade
   Ÿ Thus, the LDI manager should structure the derivative trade to focus on market
   standard features so that it will be easy to unwind positions ahead of maturity
2. Central clearing
   Ÿ This removes counterparty risk from the bank
3. Cash management with central clearing houses
   Ÿ Within central clearing, all positions are collateralised daily using cash (i.e. margin)
4. Mitigate counterparty risk for trades that are not centrally cleared
5. Documentation
6. Leverage

Question 8

Describe five different strategies for implementing a LDI portfolio

Answer 8

1. Single-tranche implementation: Reduce pension liability risk immediately by
   investing in the proper amount of bonds/swaps in the LDI portfolio to completely
   immunize interest rate and inflation risk
2. Phased implementation: Implement the interest rate and inflation hedges in the
   LDI portfolio more gradually
3. Trigger-based implementation: Implement hedges in the LDI portfolio based on
   changing market conditions
   Ÿ For example, we could increase the hedge in the LDI by 10% if interest rates reach
   3%
4. Combined approach: Combines a phased implementation with some triggers
5. Delegated implementation: The LDI manager is given full control to implement
   the hedging process over a period of 2 to 4 weeks

Question 9

Describe four main categories of LDI management style

Answer 9

1. Buy and maintain: Holdings are specified by the client, and portfolio will not be
   managed against or rebalanced to a benchmark
2. Passive: Portfolio will be rebalanced to match a target benchmark
3. Dynamic: Similar to passive, but also includes a Dynamic instrument selection
   strategy that switches between using bonds and swaps
4. Active: Overlays a core strategy with a strategy that introduces active positions
   that are not related to the hedging of the liability