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Liability Funding Strategies. General Principles of Asset/Liability Management Structuring a Portfolio to Satisfy Multiple Liabilities Extensions of Liability Funding Strategies Combining Active and Immunization Strategies. Asset-Liability Management.

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liability funding strategies
Liability Funding Strategies
  • General Principles of Asset/Liability Management
  • Structuring a Portfolio to Satisfy Multiple Liabilities
  • Extensions of Liability Funding Strategies
  • Combining Active and Immunization Strategies
slide2

Asset-Liability Management

Choose assets to meet the demand of liability. Four types of liabilities:

Type I liabilities – fixed-rate deposit, Guaranteed investment contract

Type ii liabilities – life insurance

Type iii liabilities – floating-rate CD

Type IV liabilities – property insurance, pension

(page 533)

liquidity concerns
Liquidity Concerns
  • Because of uncertainty of the timing and/or the amount of the cash outlays, an institution must be prepared to have sufficient cash to satisfy its obligations
  • Early withdraw – raise this liquidity concern; increase the difficulty of asset-liability management
  • Bear Stearns, Lehman Brother
surplus management
Surplus Management
  • Economic surplus = market value of assets – present value of liabilities
  • Example: Market value of assets is $100 million and present value of liabilities is $90 million. The modified duration of assets is 5, and the modified duration of liabilities is 3. (1) what if interest rates decline by 100 basis points? (2) what if interest rate increase by 100 basis points?
accounting and regulatory surplus
Accounting and Regulatory Surplus
  • Accounting Surplus: FASB 115, 3 possible methods for reporting
  • Amortized cost or historical cost / book value accounting
  • Market value
  • The lower of cost or market value
  • Page 536-537
  • Regulatory surplus: RAP (page 566)
immunization of a portfolio to satisfy a single liability
Immunization of A portfolio to satisfy a single liability
  • Example: consider a life insurance company selling GIC (guaranteed investment contract) which guarantees an interest rate of 6.25% every 6 months for 5.5 years. The payment made by the policyholder is $8,820,262. What is the amount of the guaranteed payment?
  • How to invest then the life insurer could immune from the interest risk?
option 1
Option 1
  • How about the portfolio manager buys $8,820,262 par value of a bond selling at par with a 12.5% yield to maturity that matures in 5.5 years?
what should be recalled
What should be recalled?
  • How to calculate accumulated value?
  • How to calculate total return?
slide9

Option 2

How about the portfolio manager buys $8,820,262 par value of a bond selling at par with a 12.5% yield to maturity that matures in 15 years?

option 3
Option 3
  • How about the portfolio manager buys $8,820,262 par value of a bond selling at par with a 12.5% yield to maturity that matures in 6 months?
slide11

Option 4

How about the portfolio manager buys $10,000,000 par value of a bond, coupon rate 10.125%, yield to maturity 12.5% that matures in 8 years?

rebalancing an immunized portfolio
Rebalancing An Immunized Portfolio
  • An implicit assumption made in option 4
  • What should a portfolio manager do?
immunization risk
Immunization Risk
  • There are many duration matched portfolios that can be constructed to immunize a liability, is it possible to construct one that has the lowest risk of realizing the target yield?
  • What strategy is the best?
goals of immunization
Goals of Immunization
  • Matching duration of assets and liabilities
  • Achieving the lowest immunization risk
  • Have the highest return
contingent immunization
Contingent Immunization
  • Combine active portfolio management and immunization
  • Safety net return
  • Safety cushion
  • Dollar safety margin
  • (Definitions see page 550-551)
example
Example
  • A client investing $50 million, is willing to accept a 10% rate or return over a 4-year investment horizon at a time when a possible immunized rate of return is 12%
slide18
What is the immunized target value?
  • What is the minimum target value?
investment strategy
Investment Strategy
  • Invest in 20-year 12% coupon bond, selling at par.
key factors in setting up a contingent immunization strategy
Key Factors in setting up a Contingent Immunization Strategy
  • Setup an appropriate target return
  • Identify a suitable safety net return
  • Design an effective monitoring procedure
strategy for multiple liabilities
Strategy for Multiple Liabilities
  • Multiperiod immunization: satisfying more than one predetermined future liability regardless of interest rates change (see conditions on page 552).
  • Cash Flow Matching: (page 553) – more costly
what is the point in this chapter
What is the point in this chapter?
  • Banks, insurance companies, and other firms have obligations to meet, their assets need to be prepared in a way best fit the structure of their liabilities.