Liability-Driven Investing

Liability-Driven Investing (LDI) is primarily an institutional investor strategy suitable for entities with known future financial obligations. Insurance companies and defined benefit (DB) pension plans are common examples.

Common Terminology

1. Asset-Liability Management (ALM) – A strategy that considers how assets align with liabilities, often used when they have similar durations.
2. Liability-Driven Investing (LDI) – Focusing on meeting known future obligations and adjusting asset management accordingly, common in insurance.
3. Asset-Driven Investing (ADI) – Concentrating on existing assets and structuring liabilities accordingly, such as in leasing companies.

Four Types of Liabilities

$$ \begin{array}{c|c|c|c}
{\textbf{Liability} \\ \textbf{Type}} & {\textbf{Amount of} \\ \textbf{Cash Flows}} & {\textbf{Timing of} \\ \textbf{Cash Flows}} & \textbf{Examples} \\ \hline
\text{Type I} & \text{Known} & \text{Known} & \text{Option free, fixed-rate bonds} \\ \hline
\text{Type II} & \text{Known} & \text{Not Known} & \text{Callable or puttable bonds} \\ \hline
\text{Type III} & \text{Not Known} & \text{Known} & \text{Floating rate bonds, TIPS} \\ \hline
\text{Type IV} & \text{Not Known} & \text{Not Known} & { \text{Property, casualty insurers,} \\ \text{some DB pension plans} }
\end{array} $$

For type I liabilities, Macaulay Duration is sufficient. This is due to their relative simplicity, having both known payment amounts and known timing of payouts. The other types require effective duration.

Question

Known cash flow amounts with unknown timing most accurately describes which liability type?

1. Type III.
2. Type IV.
3. Type II.

Solution

The correct answer is C.

$$ \begin{array}{c|c|c|c}
{\textbf{Liability} \\ \textbf{Type}} & {\textbf{Amount of} \\ \textbf{Cash Flows}} & {\textbf{Timing of} \\ \textbf{Cash Flows}} & \textbf{Examples} \\ \hline
\text{Type I} & \text{Known} & \text{Known} & \text{Option free, fixed-rate bonds} \\ \hline
\text{Type II} & \text{Known} & \text{Not Known} & \text{Callable or puttable bonds} \\ \hline
\text{Type III} & \text{Not Known} & \text{Known} & \text{Floating rate bonds, TIPS} \\ \hline
\text{Type IV} & \text{Not Known} & \text{Not Known} & { \text{Property, casualty insurers,} \\ \text{some DB pension plans} }
\end{array} $$

It is important to note that candidates may need to know not only the makeup of a liability type but also its respective number. A best practice is to memorize the examples along with the liability type and its respective number. This often helps anchor the memory as opposed to leaving the examples out of the memorization process. 

Reading 20: Liability-Driven and Index-Based Strategies

Los 20 (a) Describe liability-driven investing