QFIP-151: ALM of Financial Institutions, Ch. 5

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”

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
   Ÿ 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
   Ÿ Securities may drop out of an index due to certain factors (e.g. downgrade) and
   transaction costs at these times may be quite high
   Ÿ Passive managers will need to sell the security, and will likely incur large transaction
   costs
3. Diversification and Replication
   Ÿ 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
   Ÿ 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)