I’ve been searching over LIII/LII to try to find information on this topic to get it clear in my head. Can anyone help me understand/point to reference readings on the effect of changing interest rates (decreases and increases) on pension assets and pension liabilities? I recall reading somewhere about assets being more/less sensitive (duration?) than the liabilities and how a change in rates would affect the assets more/less than the liabilities. (I could be wrong about the location-it may necessarily be about pension, it may be about balance sheet assets & liabilities). This may not be directly related to any LIII LOS, but I want to be clear. I swear to God that last year’s pension beta calculation cost me the exam (10th percentile), but I digress. I appreciate anyone’s help. Happy New Year to all, Michael
I can’t remember exactly where, but this topic is in the LIII material, either volume 2 or 3. The gist of it however, is to compare the duration of your assets with the duration of your liabilities. For example, if your assets have a higher duration than your liabilities, your assets will lose more value than your liabilities when interest rates rise, and the opposite effect will take place when rates go the other way. Basically, the larger the difference in duration between your assets and liabilities, the greater your interest rate risk.
HT2010 Wrote: ------------------------------------------------------- > I can’t remember exactly where, but this topic is > in the LIII material, either volume 2 or 3. > > The gist of it however, is to compare the duration > of your assets with the duration of your > liabilities. For example, if your assets have a > higher duration than your liabilities, your assets > will lose more value than your liabilities when > interest rates rise, and the opposite effect will > take place when rates go the other way. > Basically, the larger the difference in duration > between your assets and liabilities, the greater > your interest rate risk. this sounds right. its called the leverage-adjusted duration gap and used by banks. it equal to duration of assets minus the ratio of Liabilities to assets times the duration of liabilities. D(a)-(L/A)*(D(L)).
The following equation comes to mind: A = L + E A.D(A) = L.D(L) + E.D(E) Therefore, E.D(E) = A.D(A) - L.D(L); Divide by E to get: D(E) = (A/E)D(A) - (L/E)D(L) [definition of D(E)] Divide by A to get: (E/A)D(E) = D(A) - (L/A)D(L) Reference: CFAI, Reading 30; Page 109; Volume 4
the interest risk created by the differences between asset duration and liability duration can be found in most companies not only banks - pension funds, insurance companies, banks etc
Florinpop, you mean in every financial services company, right ? Where virtually all assets and liabilities are financial in nature and interest bearing. Because your average small non financial company usually hardly has anything that bears interest on their asset side…
Right idea, but you have this backwards. If rates rise, your interest-rate sensitive assets (which are income producing (think adjustable rate mortgages)) will throw off larger cash flows. The opposite is true for liabilities. If you have a positive gap (more assets than liabilities, or even a higher net duration on the asset side), you will actually have higher net interest income when rates increase. HT2010 Wrote: ------------------------------------------------------- > I can’t remember exactly where, but this topic is > in the LIII material, either volume 2 or 3. > > The gist of it however, is to compare the duration > of your assets with the duration of your > liabilities. For example, if your assets have a > higher duration than your liabilities, your assets > will lose more value than your liabilities when > interest rates rise, and the opposite effect will > take place when rates go the other way. > Basically, the larger the difference in duration > between your assets and liabilities, the greater > your interest rate risk.