Liability Funding Strategies

1
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

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)
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?

4
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 466
• Regulatory surplus RAP (page 467)

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?

6
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?

7
What should be recalled?

• How to calculate accumulated value?
• How to calculate total return?

8
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?
9
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?

10
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?
11
What Have We Learnt?
12
Rebalancing An Immunized Portfolio

• An implicit assumption made in option 4
• What should a portfolio manager do?

13
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?

14
Goals of Immunization

• Matching duration of assets and liabilities
• Achieving the lowest immunization risk
• Have the highest return

15
Contingent Immunization

• Combine active portfolio management and
  immunization
• Safety net return
• Safety cushion
• Dollar safety margin
• (Definitions see page 480)

16
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

17

• What is the immunized target value?
• What is the minimum target value?

18
Investment Strategy

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

19
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

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)

21
Combining Active and Immunization Strategies
See the formula on page 486.
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.

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) dont worry about it.