How would you hedge the non parellel shift in yield curve? I am not sure how to hedge with Futures, options , swaps etc. The topics covered in those chapters refer only to duration which is mostly parellel shift. The things I remember is , you can hedge non parellel shifts by ( if you have liabilities) 1) Matching the PVD of liabilities 2) Minimizing reinvestment risk 3) 2 bond hedge, but this is not perfect and I only recall this for MBS If you dont have liabilities, how would you hedge ? Can we hedge using Options, futures or swaps. Thanks
I’m not sure if this was covered in the curriculum (other than the MBS case), but presumably you would do it by hedging key rate durations. Treasury futures come in different maturities (2y, 5y, 10y) and you can try to use a “hedge portfolio” of treasury futures where the key rate duration of the futures portfolios offset the key rate durations of your regular portfolio and the total duration adds up to the duration of your regular portfolio. You might be able to do it with options and caps and swaps and things too, but that’s even more complex. Other than the concept of trying to match key rate durations, I think this type of problem is too complex to have any likelihood of showing up on the exam, but someone else who is in final-cram-mode can certainly correct me if I’m wrong.
I also recall PVD is used more from a benchmarking perspective to hedge twists/shifts, not as much to hedge from an ALM perspective, but at the end of the day, your trying to benchmarkmark your liabilities so I guess it would make sense. Also, not to hijack the thread, but when we are saying we are immunized against liabilities, is that appropriate if our duration of assets matches liabilities? I would say “no”, if the spread of our horizon cash flows are wide about the liability cash flows, hence exposing us to reinvestment risk. Thoughts?
To be immunized, duration has to match, and the PV of assets >= PV liabilities. Cash flow matching is the most perfect (and expensive) way to match. If the cash flows don’t match each other, but duration matches, then you’re gong to have to adjust your durations over time, which will a) require more work, and b) rack up transaction costs, and c) if there is a convexity mismatch, you’ll have a little bit of leftover risk for large interest rate changes. Even though there is technically reinvestment risk if cash flows mismatch, the idea of duration matching is that any loss in reinvestment opportunities is offset by the rise of bond prices when the interest rate drops, so the risks cancel each other out. The work comes in because durations change as bonds get closer to maturity, and the way they change depends on the timing of the cash flows. So you might be immunized at one point in time, but a year or two later, the duration of your assets and your liabilities may have changed at different rates unless you do cash flow matching and you are no longer immunized.
I believe key rate durations is correct . For Mbs it wd be the 2 bond hedge .
You are a beast Bchad. I probably look at it totally wrong. When I think immunized portfolio, I think of stand alone assets not meant to hedge a liabiltity. You are trying to make your portfolio neutral to inerest rates. When I think duration matched portfolio, I think you trying to hedge in the following manner; rates fall (shift), and durations are matched, so both asssets and liabilties rise by the same amount. Now for twists, I imagine you would just look at the key rates of liabilities and match them in your assets, so essentially, you are properly weighting your cash flows to tighten arunf liabilitiy CF’s I dont see reinvestment risk being a central issue in duration matching, rather price risk. If you are duration and key duration matched, then your CF reinvestment will approx. match liability reinvestment. Does that make sense Bchad?
- Match Key rate durations or 2)Find the duration matched portfolio with the least amount of immunization risk. To do this you find portfolios with a value of at least equal to the present value of the liability to be funded and whose durations are equal to the time the liability is due. Then choose the portfolio with the minimum maturity variance. This optimization process can be accomplished through liner programming.
Key rate duration and convexity adjustments needed. PVD takes both of these into account (from what I understand). It is under the section on FI indexing. I don’t think this is really discussed anywhere else in the texts.
mwvt9 Wrote: ------------------------------------------------------- > Key rate duration and convexity adjustments > needed. > > PVD takes both of these into account (from what I > understand). It is under the section on FI > indexing. I don’t think this is really discussed > anywhere else in the texts. I agree with you.
PhillyBanker Wrote: ------------------------------------------------------- > You are a beast Bchad. I probably look at it > totally wrong. When I think immunized portfolio, I > think of stand alone assets not meant to hedge a > liabiltity. Hmm… as far as I know, immunization is about ensuring that the money you have today will be enough to cover the liabilities you have tomorrow no matter what interest rates do. (it’s about immunizing against interest rates, because having a liability is like being short a zero-coupon bond, so they’re best hedged with fixed income, which in turn is most affected by interest rates) So the PV(assets) >= PV(liabilities) is about making sure you have enough money today. And the Duration(assets) = Duration(liabilities) is about making sure it stays that way. > You are trying to make your portfolio > neutral to inerest rates. Yes. > When I think duration > matched portfolio, I think you trying to hedge in > the following manner; rates fall (shift), and > durations are matched, so both asssets and > liabilties rise by the same amount. Now for > twists, I imagine you would just look at the key > rates of liabilities and match them in your > assets, so essentially, you are properly weighting > your cash flows to tighten arunf liabilitiy CF’s Yes. It’s good if your cash flows match in timing because that will keep your key rates equal. But, if you’re willing to take on yield curve risk (which is really an active management decision), you might match total portfolio duration only and not match key rates. > I dont see reinvestment risk being a central issue > in duration matching, rather price risk. If you > are duration and key duration matched, then your > CF reinvestment will approx. match liability > reinvestment. I can’t prove it off the top of my head, but I suspect that if you match your duration and key rate durations, then your cash flows are going to have to match pretty closely. If that’s true, then the implication is that - as you said - your CF reinvestment will approx. match liability reinvestment (except that liabilities don’t really reinvest, do they? unless you take on debt to pay them.) But the main point about duration matching is that when durations are matched, the reinvestment risk is balanced against the price risk. That’s what’s special about having the durations matched. If there’s a mismatch in durations, you’re going to be overexposed to one risk or the other - which one you’re exposed to depends on whether the asset duration is higher than the liability duration (you have more price risk) or lower (more reinvestment risk). > Does that make sense Bchad?
YES. Thanks man. Makes perfect sense. Now I got it. Edit - You should really become an instructor. You understand this stuff intuitively.
I can’t prove it off the top of my head, but I suspect that if you match your duration and key rate durations, then your cash flows are going to have to match pretty closely. If that’s true, then the implication is that - as you said - your CF reinvestment will approx. match liability reinvestment (except that liabilities don’t really reinvest, do they? unless you take on debt to pay them.) bchadwick, Even if you match the duration and key rate duration, you will still have reinvestment risk. (Look at the paragraph on schweser above maturity variance)…
PhillyBanker Wrote: ------------------------------------------------------- > YES. Thanks man. Makes perfect sense. Now I got > it. > > Edit - You should really become an instructor. You > understand this stuff intuitively. Pretty sure bchadwick was/is an instructor.