Dangers Associated with Liability-Driven Investment

• Hedge amounts do not consider convexity. They are just approximations based on duration.
• Duration is only accurate for parallel shifts in the yield curve.
• Structural risk occurs when twists in the yield curve happen, and a zero-coupon bond may not properly immunize the liability in this case. To combat this, set asset convexity slightly higher than liability convexity.
• Measurement error can occur when weighted average characteristics of portfolio assets and liabilities are used instead of portfolio statistics based on the internal rate of return of cash flows.
• Futures BPV calculations are based on an assumed cheapest-to-deliver bond. That bond can change, which changes the futures duration and BPV, creating errors in calculations.
• If the assets in the liabilities are represented by fixed income with different risk factors, the portfolio yield and liability discount rate may differ. As an example, liability discount rates may reflect corporate debt and asset yield may reflect government bond rates.
• The use of OTC derivatives introduces counterparty risk. This represents the failure of the counterparty to fulfill their side of the contract, be it delivery or taking delivery, settling, etc.
• Finally, liquidity risk can be significant this was the case with the contingent immunization strategy that was long and in the portfolio of equities. In the case that the surplus evaporates, the portfolio consisting entirely of equities would need to be liquidated quickly.

Question

Duration is most accurate for measuring?

1. Parallel shifts and yield curve twists.
2. Parallel shifts only.
3. Yield curve twists only.

Solution

The correct answer is A.

Duration is accurate for measuring both parallel shifts and yield curve twists. When interest rates change uniformly across all maturities (parallel shift), duration provides a good approximation of price sensitivity. Additionally, duration can still offer useful insights in the presence of yield curve twists.

B is incorrect. Duration is most accurate when measuring the price sensitivity to parallel shifts, where all interest rates move by the same amount. In this context, duration provides an accurate measure. However, it’s less accurate when measuring changes in bond prices due to yield curve twists.

C is incorrect. Duration is less accurate when measuring price sensitivity to yield curve twists. In a yield curve twist, interest rates on different maturities change by different amounts or even move in opposite directions, making duration less precise for predicting bond price changes. Other measures, like key rate duration and convexity, are more suitable for assessing sensitivity to yield curve twists.

Reading 20: Liability-Driven and Index-Based Strategies

Los 20 (f) Explain risks associated with managing a portfolio against a liability structure