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• Chapter 19
•  
• Liability Funding
• Strategies

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Chapter Objectives

• After completing this chapter you should
• Understand the forms of liabilities.
• Be able to immunize a portfolio

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Types of Liabilities

• Type I amount certain, timing certain
• Fixed rate deposit
• Guaranteed investment contract (GIC)
• Type II amount certain, timing uncertain
• Life insurance policy
• Type III amount uncertain, timing certain
• Floating-rate CD
• Type IV amount uncertain, timing uncertain
• Auto and home insurance

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Liquidity Issues

• Whenever either the timing or the amount of the
  liability is uncertain, the are implications for
  liquidity.
• Firms face liquidity risk, i.e., not having
  sufficient assets that can be liquidated (without
  significant penalty or cost).

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Surplus Management

• Surplus or Asset/Liability Management
• Generate sufficient return
• Maintain surplus of asset over liabilities
• Trade-Off between risk and return
• Economic surplus
• Mkt value of assets mkt value of liabilities
• Accounting Surplus
• Generally accepted accounting principles (GAAP)

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Interest Rate Risk

• For portfolios of fixed-income securities, the
  most significant risk factor is that of interest
  rate risk.
• We need to know the sensitivity of our positions
  to changes in interest rates.
• The sensitivity of both assets and liabilities
  are importantthe net effect determines the
  surplus.

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Immunization

• Immunization strategies are those which seek to
  eliminate exposure to interest rate risk.
• The key to this is matching
• Duration, and
• Present value
• Matching cash flows does not immunize due to
  reinvestment risk!

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Immunization(contd)

• We need to balance the effects of
• Reinvestment risk, and
• Price risk.
• A portfolio is immunized if the assets and
  liabilities
• Match in modified (or with embedded options
  effective) duration, and
• Match in present value.

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Immunization(contd)

• Excel Spreadsheet Immunization

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Rebalancing

• Immunization is instantaneous
• As time passes and market conditions change,
  portfolios must be rebalanced.
• Trade-off
• Cost of rebalancing, vs.
• Cost of risk exposure

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Immunization Risk

• Immunization assumes that the yield curve makes
  parallel shifts.
• Minimizing immunization risk
• Immunization risk largely reduces to reinvestment
  risk
• Fong and Vasicek measure