P4-Strategies for managing liabilities

Question 1

Explain the concept of imunization

Answer 1

Is a fixed income processes that PM match the liability with a bond w/ zero coupon with same duration.

Question 2

Remember the concept of macaulay duration

Answer 2

Is the weighted avg. time until PV cash flow of an instrument are received @ YTM.

Question 3

Explain the concept of price risk in fixed income context

Answer 3

Uncertainty of proceeds if a bond must sold brefore maturity.

Question 4

Explain the concept of reinvestment risk in fixed income context

Answer 4

The risk of reinvest the proceds at the same return

Question 5

Remember the diference between macaulay and modified duration and why do that

Answer 5

Modified dur is the macaulay divided (1+ytm> used to discount cf)

-Slightly more accurate
-Slightly more appropriate measure for immunization techniques

Question 6

Whats the goal to the imunized portifolio - think about target and explain the additional measure for increase the acurracy

Answer 6

The goal of the 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.
Convexity can be a complement for increase accuracy of % change in portifolio.

Question 7

In context of imunization, explain the concept of structural risk.

Answer 7

Creating portifolio duration w/ different asset durations (L and H) vs. liabilities (M only).

Question 8

In a context of immunization, explain the concept of steepening twist. For this context we have the following components:

• S,L shorter and longer term assets
• M medium term liabilities

Answer 8

Increase in yield H while decrease in S, no change in M.

Question 9

In a context of immunization, explain the concept of flattening twist. For this context we have the following components:

• S,L shorter and longer term assets
• M medium term liabilities

Answer 9

Decrease in yield H while increase in S, no change in M.

Question 10

In a context of immunization, explain the concept of positive/ negative butterfly twist. For this context we have the following components:

• S,L shorter and longer term assets
• M medium term liabilities

Answer 10

Negaive is oposite.

Question 11

Explain the steps for imunizing a single liabilite

Answer 11

1) Port market value = Present value liabilitie
2) Duaration matches
3) Minimize port convexity
4) Regulary rebalance

Question 12

Explain the duration matching process, little bit different, but allow to fund mutiple liabililities (steps 4)

Additional task, explain why better to have an asset with slight higher duration?

Answer 12

Additional taks:

In a cenario of reducing yield a higher duration asset will give a boost on asset PV value over liabilitie reducing STRUCTURAL RISK.

Question 13

Explain the strategy of contingent imunization (CI)

Answer 13

Separe a surplus that can be invested into equity, commodities, real estate, and other assets. Can actively managed, if imunization strategy fail surplus can save otherwise can be distributed as additional source of return.

Question 14

In a example of imunization of a DB pension plan explain why the floating rate leg has a negative duration?

Answer 14

You receive floating payments → it’s like being long a floating bond → duration is negative because floating-rate instruments are almost insensitive to rate changes NEAR ZERO.

You pay fixed → it’s like being short a fixed bond → duration is positive because paying fixed increases your exposure to rising rates.

Question 15

Explain the strategy of pure index or full replication.

Answer 15

Is holding ALL securities and weighting them as in the index.

Question 16

Formula for calculate the number of contracts needed for imunizing a liabilitie w/ bond

Answer 16

Question 17

What are payer and receiver swaptions, and how do they relate to hedging interest rate risk?

Answer 17

A payer swaption gives the buyer the right to pay fixed, receive floating.

A receiver swaption gives the buyer the right to receive fixed, pay floating.
👉 The name always refers to the fixed leg action of the buyer.

A payer swaption gains value if interest rates rise, since the buyer can pay below-market fixed.

That means loss to the seller, who must now accept a below-market fixed rate.

🎯 Reduce interest rate risk, especially when:

Liabilities have higher BPV than assets

If rates fall, liabilities increase more in value than assets → loss
✅ Hedging with swaptions can help reduce this imbalance.