Liability driven investing

RD 22- example 7 page 87, problem # 2- i do not understand the logic behind this at all.

Can anyone explain this to me?

Also example 8 on page 91 q 1

Which part specifically

swaption part

This discussion can get technical, so I’ll try a broad approach here.

You are trying to close the duration gap here between the assets and liabilities of a pension plan. Put simply, the liabilities have a larger money duration than the assets. This makes sense because pension are long-term plans typically.

You have three choices of derivatives to increase the duration of the assets:

  1. Receive-fixed swap

  2. Receiver swaption

  3. Swaption collar

When using a receiver swaption, you have an option to buy a swap at a strike interest rate. The receiver swaption is more valuable as interest rates decline. When interest rates decline, you would exercise the option to buy the receive-fixed swap. The payoff gets larger as the interest rate is lower. Like any option, if you choose not to exercise the receiver swaption, you only lose the premium paid.

Hope this helps,

Keith