Fin431x (Ch 21) 1 Liability Funding Strategies 1.General Principles of Asset/Liability Management 2.Structuring a Portfolio to Satisfy Multiple Liabilities.

Fin431x (Ch 21) 1

Liability Funding Strategies

1. General Principles of Asset/Liability Management

2. Structuring a Portfolio to Satisfy Multiple Liabilities

3. Extensions of Liability Funding Strategies

4. Combining Active and Immunization Strategies

Fin431x (Ch 21) 2

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 463)

Fin431x (Ch 21) 3

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 duration of assets is 5, 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?

Fin431x (Ch 21) 4

Accounting and Regulatory Surplus

Accounting Surplus: FASB 115, 3 possible methods for reporting

(1) Amortized cost or historical cost / book value accounting

(2) Market value

(3) The lower of cost or market value

Page 466

Regulatory surplus: RAP (page 467)

Fin431x (Ch 21) 5

Immunization of A portfolio to satisfy a single liability

Example: consider a life insurance company selling GIC which guarantees an interest rate of 6.25% every 6 months. 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?

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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?

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What should be recalled?

How to calculate accumulated value?

How to calculate total return?

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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?

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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?

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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?

Fin431x (Ch 21) 11

What Have We Learnt?

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Rebalancing An Immunized Portfolio

An implicit assumption made in option 4

What should a portfolio manager do?

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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?

Fin431x (Ch 21) 14

Goals of Immunization

(1) Matching duration of assets and liabilities

(2) Achieving the lowest immunization risk

(3) Have the highest return

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Contingent Immunization

Combine active portfolio management and immunization

Safety net return

Safety cushion

Dollar safety margin

(Definitions see page 480)

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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%

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What is the immunized target value?

What is the minimum target value?

Fin431x (Ch 21) 18

Investment Strategy

Invest in 20-year 12% coupon bond, selling at par.

Fin431x (Ch 21) 19

Key Factors in setting up a Contingent Immunization Strategy

(1) Setup an appropriate target return

(2) Identify a suitable safety net return

(3) Design an effective monitoring procedure

Fin431x (Ch 21) 20

Structure A portfolio to satisfy multiple liabilities

Multiperiod immunization: satisfying more than one predetermined future liability regardless of interest rates change (see conditions on page 482).

Cash Flow Matching: (page 484) – more costly (skipped)

Fin431x (Ch 21) 21

Combining Active and Immunization Strategies

See the formula on page 486.

Fin431x (Ch 21) 22

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.

Fin431x (Ch 21) 23

Exercises – ch21

Problem 20 – 45.45%

Problem 21 – (a) reinvestment risk, price risk, etc. (b) the assets backing the liabilities may not earn a high rate. (c) don’t worry about it.