Reading 10 Flashcards
Asset-liability management
Strategies that consider assets in relation to liabilities
Liability driven investing
taking liabilities as a given and manages assets to meet those future liability values
asset driven investing
takes the assets as a given and managers or adjusts the liabilities in relation to those assets eg a leasing company with specific types of floating or fixed rate financial assets may structure its liabilities to match the characteristics of those assets
Describe the different types of liabilities (type 1,2,3,4)
Type I: known future amounts and payout dates
Type 2: known future amounts but uncertain payout dates
Type 3: uncertain future amounts but known payout dates
Type 4: uncertain future amounts and uncertain payout dates: eg property and casualty
Immunization
fixed income management process in which the portfolio is managed to minimize the variability of the rate of return earned over a specified time period ie future value of portfolio can be predicted, and if enough funds are invested initially, known future liability can be funded
The goal of immunized portfolio is to earn the initial portfolio IRR, not the average YTM of the bonds. Earning the IRR means the portfolio will grow to a sufficient FV to fund the liability
Macaulay Duration
weighted average time until the cash flows of an instrument are received.
Macaulay of 0 coupon bond = maturity
Macaulay of non-zero coupon bond: less than maturity
It is also a balance point where reinvestment and price risk offset each other
Price Risk
uncertainty of proceeds if a bond must be sold before maturity
Reinvestment risk
uncertain FV of any cash flows received and reinvested before the end of the holding period
Formula for modified duration
Macaulay duration/ (1+ YTM)
How is convexity related to Macaulay duration?
[( MacD ^2 + MacD + dispersion/ ( 1 + IRR)^2
How does parallel shift in yield curve upwards impact our PVA and PVL if PVA is slightly higher than PVL?
For a large parallel increase in the curve, the immediate decrease in portfolio value will be less than the decrease in the PVL due to the positive convexity effect. With the parallel increase, the new portfolio IRR will increase by basically the same amount as the increase in discount rate for the PVL. In other words, the future rates of increase in A and L will be the same, but starting from a new PVA that is relatively higher than the PVL, the FVA will exceed the FVL.
How does parallel shift in yield curve downwards impact our PVA and PVL if PVA is slightly higher than PVL?
Large parallel decrease in the curve, the immediate increase in portfolio value will exceed the increase in PVL due to positive convexity effect. With the parallel decrease, the new portfolio IRR will decrease by basically the same amount as the decrease in discount rate for the PVL. In other words, the future rate of increase in A and L are still the same, but starting from a new PVA that is relatively higher than the new PVL, the FVA will exceed the FVL.
You have L, M and H and see a steepening twist - what happens to portfolio value?
Decreases because the decline in value of longer duration bond will exceed the increase in value due to shorter duration bond.
PVL (M) will be unchanged with no change in yield M. PVA will now be below PVL.
That by itself does not indicate the strategy will fail. If portfolio IRR increases sufficiently, the required FV might still be reached,
You have L, M and H and see a flattening twist. What happens to portfolio value?
Increases because the increase in value of the longer duration bond will exceed the decrease in value of the shorter duration bond.
PVL will be unchanged with no change in yield M.
PVA is now above PVL.
That by itself does not indicate the strategy will succeed. If portfolio IRR decreases sufficiently, the required FV of assets to meet the payout may not be reached.
What happens to portfolio value in a positive butterfly twist?
Decreases
both yield L and H increase, decreasing asset value
PVL increases as yield M decreases -> PVA now below PVL
While it is detrimental, it is possible the strategy could still succeed if portfolio IRR increases enough versus the decrease in liability discount rate.
What happens to portfolio during negative butterfly twist?
L and H decrease while M increases.
Portfolio market value increases as both yield L and H decrease. PVL will decrease as yield M increases. PVA is nwo clearly above PVL.
This is favorable, but does not guarantee the strategy will succeed if the portfolio IRR decreases too much in relation to the increase in liability discount rate.
What are the rules for immunizing a single liability?
- PVA greater than or equal to PVL
- Portfolio MacD matches due date of liability
- Minimize portfolio convexity (to minimize dispersion of asset cash flows around the liability and reduce risk to curve reshaping)
- regularly rebalance the portfolio to maintain the duration match as time and yields change, but also consider the tradeoff between higher transaction costs from more frequent rebalancing versus the risk of allowing durations to drift apart.
Money Duration
Money change in value of assets or liability for change in interest rates
Money duration (BPV)= modified curation * value of asset or liability * 0.0001
also called price value of a basis point
Accounting Defeasance
assets are legally set aside and dedicated to meet the liabilities - allowing both those assets and liabilities to be removed from the balance sheet of the organization responsible for paying the liability.
Cash in advance constraint
requires bonds used to fund a specific liability to mature before the required payout date of the liability. This would expose the portfolio reinvestment risk in an upward sloping yield curve.
The upward sloping yield curve is anticipated to create reinvestment risk because as cash comes in to be reinvested for a short time period until payout, the reinvestment must be at the lower rates at the short end of the curve.
Laddered Portfolio
Roughly equal par amounts purchased across different maturities.
What are the advantages of laddered portfolio?
- has regular liquidity as some bonds come due each year.
- Broad diversification of cash flows across time and yield curve and less concentrated exposures to nonparallel changes at specific maturities on the curve.
- There is diversification between price risk on long-dated bonds and reinvestment risk on short-dated bonds.
- has more convexity than a bullet
What are the rules for immunizing multiple liabilities?
- initial PVA greater than or equal to PVL
- Portfolio and liability basis point values match BPV A= BPVL
- Asset dispersion of cash flows and convexity exceed those of the liabilities (but not by too much, in order to minimize structural risk exposure to curve reshaping)
- regular rebalancing of the portfolio to maintain BPV match of A and L as time and yields change
Futures BPV
BPV (cheapest to deliver) / CF (cheapest to deliver)
Number of contracts required to adjust portfolio assets
[BPV of liability - BPV of current portfolio] / BPV of futures
Contingent Immunization
Hybrid active/passive strategy and requires a significant surplus. As long as surplus is of sufficient size, the portfolio can be actively managed.
Benefit of IRS over futures?
OTC, so can avoid margin
In IRS, which leg increases duration?
receive fixed leg -> equivalent to buying a bond and increases portfolio duration
pay fixed swap reduces duration
Swap’s net duration
Difference between fixed and floating rate bonds that would replicate the swap’s future coupon flows
Net swap BPV
fixed side BPV - floating side BPV
Notional swap principal required for hedge
= [duration gap in BPV ] / ( swap BPV per 1 NP)
How does Swap fixed rate/ swaption strike rate impact?
If SFR new declines, right to receive a now above market SFR has positive value and effectively increases the BPV of the assets. The value of the swaption is part of portfolio assets and increases total value of plan assets
If SFR new increases, the right to receive is now below market SFR and has no value, the swaption will not be exercised, and it would be allowed to expire worthless. Note that if a swap had been used instead of a swaption, the plan would suffer escalating lossess on a receive fixed swap.
If BPV of assets is lower than liabilities, you already have a 50% hedge and want to reduce to a 30% hedge, what do u do with swaptions?
enter a pay fixed swaption for 15%
collar to increase duration
enter a zero cost collar to buy receiver swaption and sell payer swaption
Pure Index/ Full replication approach
Requires holding all securities and weighting them as in the index
Enhanced indexing
matches all primary risk exposures of the index, but not all the holdings. the goal is more efficient tracking of the index by avoiding some of the overly costly transactions required for pure indexing
when is a zero-cost collar optimal?
Buy receiver and sell payer swaption
optimal if interest rates in the future are moderately higher (ie between the swap and payer swaption SFRs)
How can passive bond market exposure be achieved?
- separately managed account that replicates the index
- index mutual funds, either open ended or ETFs
- synthetic strategies, such as receiving bond index return under a total return swap
Given 3 portfolios, how do you identify the one with the greatest structural risk?
- see if it is bullet/ laddered/ barbell. Barbell -> more risk.
- check for convexity.
How do you identify which bond portfolio is mroe desirable for liquidity management?
Laddered/ bullet/ barbell
laddered is better for liquidity management because there is alwats a bond close to redemption, the soon-to-mature bond can provide emergency liquidity needs.
What is model risk?
Model risk arises whenever assumptions are made about future events and approximations are used to measure key parameters. The risk is that those assumptions turn out to be wrong and the approximations are inaccurate, a non-parallel yield curve shift can occur, resulting in a mismatch of the duration of the immunizing portfolio versus the liability,
which indexing method is best to ensure most cost effective method to track the benchmark while having a low tracking error?
Enhanced indexing
Low tracking error requires an indexing approach. A pure indexing approach for a broadly diversified bond index would be extremely costly because it requires purchasing all constituent securities in the index.
A more efficient and cost-effective way to track the index is an enhanced indexing strategy, whereby you would purchase fewer securities than the index, but would match primary risk factors reflected in the index. Closely matching these risk factors could provide low tracking error.
Is it easy to arbitrage bond ETFs?
No
many fixed income securities are either thinly traded or not traded at all. this situation might allow such a divergence to persist.
If a PM is focusing on interest rate sensitivities of asset liability management, which investment process are they following?
asset-liability management
Which method is better for ESG considerate investors - total portfolio replication or enhanced indexing?
enhanced indexing - they can include or exclude some sectors
How do you minimize structural risk?
Structural risk from immunization arises from twists and non-parallel shifts in the yield curve. It is reduced by minimizing the dispersion of cash flows in the portfolio, which can be accomplished by minimizing the convexity for a given cash flow duration level.
Benchmark characteristic : Valuation occurs on a weekly basis, because many of the bonds in the index are valued weekly.
is this a good benchmark?
No
The use of an index as a widely accepted benchmark requires clear, transparent rules for security inclusion and weighting, investability, daily valuation, availability of past returns, and turnover. Because the custom benchmark is valued weekly rather than daily, this characteristic would be inconsistent with an appropriate benchmark.
Which duration do you match in the immunization process?
Macaulay duration
An investor having an investment horizon equal to the bond’s Macaulay duration is effectively protected, or immunized, from the first change in interest rates, because price and coupon reinvestment effects offset for either higher or lower rates
For an immunized liability, what happens with an upward shift int he yield curve?
an upward shift in the yield curve reduces the bond’s value but increases the reinvestment rate, with these 2 effects offsetting one another.
The price effect and the coupon reinvestment effect cancel each other out in the case of an upward shift in the yield curve for an immunized liability.
How can you minimize the effect of a non-parallel shift in yield curve for an immunized portfolio?
minimize convexity of the bond portfolio
If you want diversification over time and liquidity, which portfolio structure should you use?
Laddered portfolio
are fixed income indexes easy to value versus equity?
no
equity securities typically trade much more frequently than debt securities, so current market valuations are available. many fixed income securities are very iliquid, trading very infrequently. therefore, pricing and valuation are difficult and such estimations as matrix pricing, which are subject to error, must be used,
Do you need an active derivatives market for synthetic strategies?
No.
A total return swap could be entered into in the OTC market to achieve exposure to the desired index
