Reading 19: Liability-Driven & Index-Based Strategies

Question 1

Types of Liabilities

Answer 1

Type 1: known amount and date.
Type 2: known amount but uncertain dates
Type 3: uncertain amounts but known dates
Type 4: uncertain dates and amounts

Question 2

Immunisation

Answer 2

Funding a known future liability with a portfolio of bond (s) to minimise the variability of returns over that period. Cash flow matching is the simplest form (buying a zero coupon bond with par matching liability) with no cash flow or price risk. However there may not be any appropriate zero coupon bonds available. Macauley duration matching is the other method where price and reinvestment risk offset each other at Macauley’s duration. Used to lock in the cash flow yield of the portfolio. Goal is to earn the initial portfolio IRR needed to fund the liability.

Question 3

Model Risk

Answer 3

Exists whenever assumptions are made about future events and approximations are used to measure key parameters. The risk is that they turn out wrong.

Question 4

Bums Problem

Answer 4

Market cap weighted portfolio increasing the weight of a particular issuer that has lots of debt, issuers with lots of debt are usually low quality.

Question 5

Indexing Approach

Answer 5

Involves low tracking error. Pure indexing would be costly as they need to buy every security. Enhanced indexing can reduce this cost as you buy less but match the risks. Pure indexing provides greater diversification with more securities. Enhanced can be good for ESG as the securities can be customised to reflect client preferences.

Question 6

ETFs

Answer 6

Although a gap between NAV and share price could usually be arbitraged by authorised participants, with fixed income it can persist due to illiquid bonds.

Question 7

Convexity

Answer 7

This is the desperation of cashflows around the duration. If it is too high it creates structural risk when the yield curves twists. Structural risk is reduced by minimising the dispersion of cash flows in the portoflio. The portfolio’s convexity should be higher than the liabilities convexity but as low as possible above this. Increases returns if there are large parallel shifts.

Question 8

Computing Portfolio Statistics

Answer 8

For asset - liability management it is more accurate to aggregate the portfolio cash flows to find the statistics (yield, duration, convexity etc). However many just use the weighted average of bonds in the portfolio and accept the minimal increase in error this causes.

Question 9

Duration Gap

Answer 9

Difference between the asset and liability BPV. If you buy forward contracts you can reduce the gap by increasing asset duration.

Question 10

Contingent Immunisation

Answer 10

Managing the surplus of the portfolio. If the surplus declines to zero you will need to switch to immunise the portfolio immediately.

Question 11

Using Swaps

Answer 11

Receive fixed increases the duration. Payer swap (pay fixed) will decrease the duration.

Question 12

Passive Bond Market Exposure

Answer 12

Mutual funds, well suited for smaller investors (economies of scale). Open ended fund shares can be redeemed or purchased at NAV once per day, they do not typically mature. ETFs, continuous trading but discount to NAV can persist with illiquid bonds. Total return swaps to receive a bond index return in exchange for paying LIBOR + spread (negative index return means you pay this too).

Question 13

Barbell

Answer 13

Having maturities on each side of the duration. Can cause structural risk if it is too big. An alternative is laddering where there’s a constant maturity and is good for liquidity management, good diversification, diversification of price and reinvestment risk, more convexity than a bullet which is good if there are large parallel shifts.