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Fixed Income

In Liability Driven Strategies, reading 19, one possibility is that the plan sponsor allows the manager some flexibility in selecting the hedging ratio. This flexibility in selecting the hedging ratio can be called strategic hedging. For example, the mandate could be to stay within a range of 25% to 75%. 

When the manager anticipates lower market rates and gains on receive-fixed interest rate swaps, the manager prefers to be at the top of an allowable range - I did not understand this, why manager prefers to be at the top of an allowable range.

Can someone pls help.

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If market rates decline:
- the value of bonds (asset) increases (i.e. gain)
- the value of liabilities also increases (i.e. loss)
- the value of receive-fixed IRS also increases (i.e. gain)

When Asset BPV < Liability BPV, the liability value will increase more than the increase in the asset value (i.e. plan surplus declines).

To hedge the plan liabilities, the plan manager will use receive-fixed IRS (positive BPV) to match the Asset BPV towards the Liability BPV.

When hedging the plan liabilities using receive-fixed IRS, the equation is as follows:

Asset BPV + (Notional x BPV of receive-fixed IRS per $1 notional) = Liability BPV

Case 1: Allowable hedging range is between 25% to 75% when Asset BPV < Liability BPV

So, if the plan manager expects market rates to decline, the plan manager will hedge 75% of the liability BPV using the receive-fixed IRS. In this case:

Asset BPV + (Notional x BPV of receive-fixed IRS per $1 notional) < Liability BPV

where:

Asset BPV + (Notional x BPV of receive-fixed IRS per $1 notional) = 75% x Liability BPV

When market rates decline, the increase in the value of (Assets + Receive-fixed IRS) will offset 75% of the increase in the liability value, so this minimises the decline in the plan surplus.

Case 2: Allowable hedging range is between 25% to 125% when Asset BPV < Liability BPV

So, if the plan manager expects market rates to decline, the plan manager will hedge 125% of the liability BPV using the receive-fixed IRS. In this case:

Asset BPV + (Notional x BPV of receive-fixed IRS per $1 notional) > Liability BPV

where:

Asset BPV + (Notional x BPV of receive-fixed IRS per $1 notional) = 125% x Liability BPV 

When market rates decline, the increase in the value of (Assets + Receive-fixed IRS) will be 125% of the increase in the liability value, so this maximizes the increase in the plan surplus.

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Find useful resources on the CFA exams at http://www.youtube.com/c/FabianMoa

Many thanks for the detailed revert.. :) This helps..

You’re welcome yes

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Find useful resources on the CFA exams at http://www.youtube.com/c/FabianMoa

Whats the difference between Hedging and Defeasance? Is the objective same? In Defeasance, we match liabilities with assets and we can take them off the balance sheet. 

gargijain wrote:

Whats the difference between Hedging and Defeasance? Is the objective same? In Defeasance, we match liabilities with assets and we can take them off the balance sheet. 

Hedging stays on the B/S.

mrow

Can someone pls help me understand the following- (Inter-market Carry trade)

Borrow in the higher rate currency, invest the proceeds in an instrument denominated in that currency, and convert the financing position to the lower rate currency via the FX forward market (buy the higher rate currency forward versus the lower rate currency).

Can someone pls help me understand the following-

Borrow in the higher rate currency, invest the proceeds in an instrument denominated in that currency, and convert the financing position to the lower rate currency via the FX forward market (buy the higher rate currency forward versus the lower rate currency).

I mean, when we can execute the other 2 strategies, why enter into this?

  1. Borrow from a bank in the lower rate currency, convert the proceeds to the higher rate currency, and invest in a bond denominated in that currency. OR

  2. Enter into a currency swap, receiving payments in the higher rate currency and making payments in the lower rate currency.

In order to eliminate currency exposure in an inter-market trade, the investor must, explicitly or implicitly, both borrow and lend in each currency. Among the ways to implement this trade are the following:

  • Take a long position in bond (or note) futures in the steeper market and a short futures position in the flatter market.

Can someone pls help understand..