QFIP-151-20: Ch. 5 of Asset Liability Management of Financial Institutions

Question 1

Describe the “policy portfolio approach” and state two disadvantages.

Answer 1

“Policy portfolio approach” - manager can rebalance asset allocation as it deviates from some long-term optimal amount
Two problems with the policy portfolio approach:

1. If the asset portfolio has already significantly underperformed the liabilities, there may be no unlevered mix of assets that can meet the return expectations
2. Policy portfolio reallocations suffer from the “curse of mean variance”
   
   1. “Curse” simply means that calculations for the optimal weghts are based on many parameters (mean, variance, covariance) that are highly subjective
   2. The parameters will depend on time horizon, timestep, distribution assumption (e.g. normal) and be highly uncertain and subjective

Question 2

Compare active vs passive mandates

Answer 2

• Active mandates - let the manager with expertise take small exposures beyond the benchmark to generate returns that over time are better than the benchmark with no significant increase in economic risk to the portfolio
• Passive mandates - authorize managers to invest only in benchmark securities, with the goal of benefitting from bulk execution costs and index replication strategies without additional risks

Question 3

State the three shortcomings of common fixed-income indices

Answer 3

1. Adverse Selection Bias
   
   • Market value weighted bond indices have higher weights in large issuers with high debt, leading to a dilution of the credit quality of the bond index
2. Transaction Costs
   
   • Securities may drop out of an index due to certain factors (e.g. downgrade) and transaction costs at these times may be quite high
   • Passive managers will need to sell the security, and will likely incur large transaction costs
3. Diversification and Replication
   
   • Managers often follow a replication algorithm to minimize tracking error of the portfolio to an index, but tracking error may not reflect risk well in a stressed market environment
   • Transaction costs and the total return swap premium can lead to a loss of alpha

Question 4

State the recommendations for setting shock magnitudes

Answer 4

1. Shock magnitude has to be large enough to capture a large portion of the factor risk
2. Shock magnitude has to be realistic in the context of historical and anticipated future outcomes
3. Need to consider what values are mathematically allowed in the modeling framework (the arbitrage bounds)

Question 5

Steps to Managing Assets & Liabilities with ALM

Answer 5

1. Identification of a proper benchmark that matches the liability stream
   
   • For a pension fund, the appropriate benchmark should be a near risk-free security
   • Could use TIPS as a benchmark for pension funds
2. Selection of managers with known expertise in their sectors
   
   • Need to set limits on deviations from the benchmarks (i.e. systematic risk, security concentration limits)