section 7

Question 1

for fixed income / bond portfolios what two objectives can be in mind for managing?

Answer 1

1) matching some future liability (e.g. pension fund or insurance company)
2) achieving or surpassing a benchmark (a bond index usually)

Question 2

what is cash matching and dedication

Answer 2

the purchase of bonds by investing institutions (e.g. a pension fund) so that the cash received from the coupons and principal at each period exactly matches each cash outflow from the institutions.

Question 3

what risk does catch matching and dedication not carry

Answer 3

no reinvestment rate risk and no interest rate risk (since no bonds have to be sold before maturity) - so shifts in the yield curve do not have adverse effects.

Question 4

What is duration and immunisation as an approach ?

Answer 4

matching the duration of the portfolio with the liability duration

choose a bond portfolio with the same duration as the liability it is intended to meet - the portfolio is then ‘immunised’ from changes in interest rates

Question 5

what is duration?

Answer 5

the average maturity of a bond within a bond portfolio

Question 6

what is the equation for calculating bond duration within a portfolio?

Answer 6

(% of portfolio (by value) of bond A X bond duration) + (% of portfolio (by value) of bond B X bond duration)

Question 7

what risks does duration offset?

Answer 7

Reinvestment risk and price risk

Question 8

in immunisation / duration approach to FI when are bonds sold?

Answer 8

at their duration rather than held to redemption

Question 9

what may need to happen with immunisation approach

Answer 9

may need to be re-balanced

Question 10

what assumption is immunisation based on?

Answer 10

that there is a flat yield curve and that any shifts in that curve are parallel and occur before any payments are made to bondholders

Question 11

what is a bullet or focused portfolio in terms of immunisation

Answer 11

if the portfolio of bonds is formed with individual durations similar to the desired duration

Question 12

what is a barbell portfolio in terms of immunisation

Answer 12

if the portfolio of bonds is formed with bonds with much smaller and much larger durations than the target duration

Question 13

what is credit risk management

Answer 13

in anticipation of a change in bond quality rating a manager may trade some bond issues.

for example they may sell bonds expected to deteriorate in credit rating or buy bonds in sectors that are expected to outperform at certain stages of the economic cycle.

In doing either of these actions the manager is managing these anticipated changes in credit risk in order to outperform indices and enhance bond portfolio returns

Question 14

what is riding the yield curve

Answer 14

enhancing returns by identifying and overweighting issues that trade in a portion of the maturity spectrum that is currently undervalued.

e.g. two year bonds are currently undervalued relative to one yr bonds. buy underpriced 2 year bond hold for one year and then sell at the one year price - picking up the additional price gain

Question 15

what is liability driven investing

Answer 15

match pension fund assets to obligations usually using swaps and derivatives to hedge out inflation and interest rate risk.

Investment will meet liability

Question 16

what does the strategy of riding the yield curve assume

Answer 16

that the relative miss-pricing of the issues is maintained across the shorter investing period.

Question 17

when does immunisation risk occur?

Answer 17

when there are non-parallel shifts in the yield curve which leads to the income component of the portfolio value changing too much or too little relative to capital charge.

Question 18

what is the advantage of a barbell strategy?

Answer 18

can select from a much greater range of bonds

Question 19

what are risks of barbell strategy (and thus benefits of bullet)

Answer 19

greater range of bonds implies that there is a greater degree of immunisation risk than for bullet strategy

Question 20

how can immunisation risk be reduced?

Answer 20

if the durations of the individual bonds in the immunising portfolio are close to that of the liabilities (bullet portfolio). the non-parallel shifts in the yield curve will effect the individual bonds and the liabilities in a similar way

Question 21

when is the impact of non-parallel shifts to a yield cure more substantial?

Answer 21

if the durations of the individual bonds in the immunising portfolio differ greatly from that of the liabilities (as in barbell portfolio), even thought he duration of the portfolio itself is the same as for the liabilities

Question 22

what are the key aims of a liability driven investment strategy?

Answer 22

manage funding level risk - i.e. the variability of a scheme’s assets compared to its liabilities.

Question 23

what risks remain for a liability driven investment strategy?

Answer 23

• changes in interest rate
• changes in inflation expectations
• changes in longevity assumptions