Question regarding External Constraints and Asset Allocation (Portfolio Management)

Hi all,

On CFA III curriculum volume 1 page 411, Example 4 External Constraints and Asset Allocation.

It mentioned that to lengthen the bond portfolio duration to increase the hedge of the duration risk in the liabilities - could I know how the mechanism regarding how increasing bond portfolio duration can better hedge the liabilities?

Also, from the solution, it says If yields decline across the curve, the shorter duration bond portfolio will fail to hedge the increase in liabilities. I don’t quite understand this sentence as well.

Please help and thank you so much !

You have long term liabilities. To better hedge against these you’ll need to invest in long term bonds so that the bonds payoff as liabilities come due. Longer term bonds also increase your portfolio duration as you’re exposed to economic shocks over the longer term rather than the short term.

Buying long duration bonds will provide you a high upside in terms of bond returns if you have a high duration portfolio assuming yields fall. While your liability values increase, so does that of your long duration bond portfolio almost offsetting any increases in liability values.

Hope this helps.

1 Like

Thank you, it’s really helpful.

A further quick question, when the yields decline across the curve, is the increase in liability/bond values from the increased present value due to the lower return (discount rate)?

Yes. When yields drop the values go up.

Thank you !!