Duration management

The duration of the benchmark is 5.6, however the liability of the liability is 10.2. Which term structure will affect duration mismatch and why Flattening of the yield curve Steeping of the yield curve Large parallel shift I am having some difficulty in grasping this concept and I would appreciate if the response could address the impact of each of the above separately Thanks

I am going from first principles here, so if I am wrong, please correct me. flattening of yield curve: curve was originally steep - short term rates rise more, long term rates rise less, so the entire curve flattens out. when short term rates rise - the liability will fall in value. So duration mismatch will not be affected. steepening of yield curve: curve was flat originally, short term rates FALL MORE, Long term rates fall less - so curve steepens. Short terms rates fall - liability increases in value - so duration mismatch will become more now. ANS. Parallel shift should not affect duration mismatch, since both short term and long term rates rise or fall the same.

Duration of liability is higher than benchmark. 1) Flattening of the yield curve Long term interest rates falls Increase in the value of Liability more than the benchmark because of higher duration of liability. 2) Steeping of the yield curve Long term interest rates increases Value of liability decreases more because of higher duration. Less of a concern as compared to 1 3) Large parallel shift Downward shift will cause increase in the value of liability more than the benchmark, but duration mismatch will be of a less concern than 1.

Hi, I want know the answer…

The answer is flattening of the yield curve

Thanks cfahead! But still I don’t understand the difference between no.1 and no.3. I think, for the liability, long term interest rate is the matter of concern. If this is true, is rise in LT interest rate all have the same effect on the value of liability? Please correct my wrong understanding…

manet_5 Wrote: > But still I don’t understand the difference > between no.1 and no.3. 1) flattening of yield curve Curve was originally steep. Flattening will cause short term rates to rise & long term rates to fall. With higher duration increase in the value of liability will be more than increase in the value of benchmark (assume investable - Assets). We will expect increase in 10 year key rate to be more than the increase in 5.5 year key rate. 3) Large parallel shift Long and short term interest rates rise or fall by same %. Assume interest rates falls then the increase in the value of liability won’t be as steep as in 1. > I think, for the liability, long term interest > rate is the matter of concern. > If this is true, is rise in LT interest rate all > have the same effect on the value of liability? Any increase in long term rates would cause the value of liability to fall more than the value of assets because of duration mismatch, liability duration being more than the asset duration. Though, duration mismatch in this case looks beneficial, but mismatch is not good for immunization. For immunization, duration of liability should be same as duration of asset, otherwise price or reinvestment risk arises depending upon whose duration is higher.

Thanks, tzu! i can understand the answer!

Thanks, guys. Implicitly, “the curve was originally steep”.

I still didn’t get it. CPK says the answer is steepening worse for the duration mismatch than flattening. cfahead and tzu seem to think it is flattening that is worse for the mismatch. How come the difference of opinion? Steepening = long term rates increase : Reduces liability value more than benchmark value. Flattening = short term rates increase : Reduces benchmark value more than liability value. I feel the mismatch reduces for flattening , at the limit if short term rates are same as long term rates , their duration will be similar , so mismatch will be less pronounced for progressive flattening. so I think CPK is right

This is a very good question…but I might misunderstand it. What is the duration mismatch discussed here? Is it the difference between the benchmark duration(5.6) and the liability duration(10.2)? Are we discussing the impact of yield curve shape change on Durations, or the impact on Prices?

I think you take the durations as constant, not going to change with yield curve shape changes.We are just checking if liabilities rise faster than benchmark under which scenario Now if benchmark represents asset side of the equation and liabilities are liablities , then a higher duration for liabilities could be a problem if rates begin to fall for longer term rates. Then the liabilities rise much faster than the benchmark and you have a problem. So flattening of the yield curve is bad for the portfolio. CPK is wrong and tsu+cfahead are correct