Tiêu đề LM5 Liability-Driven and Index-Based Strategies IFT Notes.pdf ✅

LM5 Liability-Driven and Index-Based Strategies 2024 Level III Notes © IFT. All rights reserved 1 LM5 Liability-Driven and Index-Based Strategies 1. Introduction .......................................................................................................................................................3 2. Liability-Driven Investing .............................................................................................................................3 3. Managing the Interest Rate Risk of a Single Liability.........................................................................5 A Numerical Example of Immunization..................................................................................................6 4 Managing the Interest Rate Risk of Multiple Liabilities .................................................................. 16 Cash Flow Matching..................................................................................................................................... 16 Laddered Portfolios..................................................................................................................................... 18 Duration Matching ....................................................................................................................................... 21 Derivatives Overlay ..................................................................................................................................... 26 Contingent Immunization ......................................................................................................................... 27 5. Example: A Defined Benefit Pension Plan............................................................................................ 29 Model Assumptions ..................................................................................................................................... 29 Model Inputs .................................................................................................................................................. 30 Calculating Durations ................................................................................................................................. 30 Addressing the Duration Gap................................................................................................................... 31 6. Risks in Liability-Driven Investing ......................................................................................................... 35 Model Risk in Liability-Driven Investing............................................................................................. 36 Spread Risk in Liability-Driven Investing........................................................................................... 36 Counterparty Credit Risk........................................................................................................................... 37 Asset Liquidity Risk..................................................................................................................................... 37 7. Bond Indexes................................................................................................................................................... 39 Size and Breadth of the Fixed-Income Universe .............................................................................. 39 Array of Characteristics ............................................................................................................................. 39 Unique Issuance and Trading Patterns................................................................................................ 39 Primary Risk Factors................................................................................................................................... 40 8. Alternative Methods for Establishing Passive Bond Market Exposure.................................... 42 Full Replication ............................................................................................................................................. 42 Enhanced Indexing ...................................................................................................................................... 42 Alternatives to Investing Directly in Fixed-Income Securities ................................................... 44 9. Benchmark Selection ................................................................................................................................... 45
LM5 Liability-Driven and Index-Based Strategies 2024 Level III Notes © IFT. All rights reserved 2 Summary ............................................................................................................................................................... 48 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM5 Liability-Driven and Index-Based Strategies 2024 Level III Notes © IFT. All rights reserved 3 1. Introduction This reading, as the title suggests, focuses on liability-driven and index-based fixed income strategies. Sections 2–6 explain how to build fixed income portfolios by taking into account both assets and liabilities on the balance sheet, i.e., liability-driven investing. The techniques and risks associated with LDI are introduced for a single liability and then expanded to cover multiple liabilities. Sections 7–9 describe how to build fixed income portfolios that replicate an index, i.e., index-based strategies. 2. Liability-Driven Investing Asset–liability management (ALM) strategies take both assets and liabilities into account when making portfolio decisions. ALM strategies include asset-driven liabilities (ADL) and liability-driven investing (LDI). In ADL, assets are given, and the liabilities are selected to manage interest rate risk to minimize the mismatch between assets and liabilities. In LDI, liabilities are given, and the assets are structured to minimize the mismatch between assets and liabilities. This reading focuses on LDI strategies. An example of an LDI is a life insurance company that has a liability portfolio comprising insurance policies. To structure a portfolio of liabilities, it is important to understand the nature of a liability. The table below shows four different types of liability based on the amount of cash outlay and the timing of cash outlay. Exhibit 1 Liability Type Amount of Cash Outlay Timing of Cash Outlay Example Type I Known Known Traditional fixed-income bonds Type II Known Uncertain Callable and putable bonds Type III Uncertain Known Floating rate notes Type IV Uncertain Uncertain Defined benefit plan obligations EXAMPLE: Classification of Liabilities (This is based on Example 1 of the curriculum) Modern Mortgage, a savings bank, decides to establish an ALCO (asset-liability committee). Modern’s primary assets are long-term, fixed-rate, monthly payment, fully amortizing residential mortgage loans. The mortgage loans are prime quality and have loan-to-value ratios that average 80%. The loans are pre-payable at par value by the homeowners at no fee. Modern also holds a portfolio of non-callable, fixed-income government bonds (considered free of default risk) of varying maturities to manage its liquidity needs. The primary liabilities are demand and time deposits that are fully guaranteed by a government deposit insurance fund. The demand deposits are redeemable by check or debit card. The time deposits have fixed rates and maturities ranging from 90 days to three years and are
LM5 Liability-Driven and Index-Based Strategies 2024 Level III Notes © IFT. All rights reserved 4 redeemable before maturity at a small fee. In accordance with the new capital requirement by the banking-sector regulator, contingent convertible long-term bonds are issued by the savings bank and sold to institutional investors. The key feature is that if defaults on the mortgage loans reach a certain level or the savings bank’s capital ratio drops below a certain level, as determined by the regulator, the bonds convert to equity at a specified price per share. As a first step, the ALCO needs to identify the types of assets and liabilities that comprise its balance sheet using the classification scheme in Exhibit 1. Type I has certain amounts and dates for its cash flows; Type II has known amounts but uncertain dates; Type III has specified dates but unknown amounts; Type IV has uncertain amounts and dates. Specify and explain the classification scheme for the following: 1 Residential mortgage loans 2 Government bonds 3 Demand and time deposits 4 Contingent convertible bonds Solution to 1: Residential mortgage loans are Type IV assets to the savings bank. The timing of interest and principal cash flows is uncertain because of the prepayment option held by the homeowner. Homeowners might elect to prepay for many reasons, including sale of the property as well as the opportunity to refinance if interest rates come down. Therefore, a prepayment model is needed to project the timing of future cash flows. Default risk also affects the projected amount of the cash flow for each date. Even if the average loan-to- value ratio is 80%, indicating high-quality mortgages, some loans could have higher ratios and be more subject to default, especially if home prices decline. Solution to 2: Fixed-rate government bonds are Type I assets because the coupon and principal payment dates and amounts are determined at issuance. Solution to 3: Demand and time deposits are Type II liabilities from the savings bank’s perspective. The deposit amounts are known, but the depositor can redeem the deposits prior to maturity, creating uncertainty about timing. Solution to 4: The contingent convertible bonds are Type IV liabilities. The presence of the conversion option makes both the amount and timing of cash flows uncertain.