Can someone summarize how an institution would adjust the duration of assets and liabilities if they expect:
a) rising rates
b) falling rates
I would say rising rates would decrease PV of my liabilities, so I would increase duration of liabilities, while reducing duration of my assets.
Falling rates would increase PV of my liabilities so I would decrease duration of my liabilities and increase duration of my assets.
Is that correct?
You have the directions and changes down correctly. The one thing that you’re assuming is that they have direct control over the duration of their liabilities. Typically much easier to adjust the assets to match. Most of our cases for pensions, life insurance, etc don’t have much control over the liability duration and they match through adjusting the assets.
Rising rates, lower BPV of assets so the price decrease is less than liabilities. Falling rates, higher BPV of assets to benefit from a greater price increase versus liabilities.
Yep, that looks good.
Just for clarity, a rising interest rate environment means your potential returns on assets will increase in the future, so you want it to get repriced faster. This will mean that you have to shorten asset duration.
A falling rate environment means your potential asset returns will fall in the future, so you want to lock in current interest rates for as long as possible. Therefore, lengthen asset duration.
Perfect, thank you both for your explanations!!