The answer to this is outlined on page 38, but I don’t fully understand it. If anyone could help I would appreciate it:
When the text vignette says he is using standard immunization – what does that imply?
What exactly is contingent claim risk? (pls explain in very basic english like you are talking to a 5 year old).
Any color on cap risk or interest rate risk would be helpful. If it’s immunized, why isn’t the question saying he’s exposed to something like key rate duration risk instead of interest rate risk in general.
Usually you have the Assets which are put in place to meet liabilities.
If the liabilities have a duration mismatch with the assets - there may not be enough funds to pay the liabilities when they come due. As a result Porfolio manager faces the risk of bankruptcy and claims from creditors. These are contingent claims.
On the Asset side - if the assets consist of MBS / Callable bonds - when rates fall - they may get prepaid - and the manager now has to reinvest the returns at a lower rate. [Yes this is reinvestment rate risk, too]. The point about using Contingent Immunization to meet the liability payments when rates move so as to match the reinvestment rate risk with the price risk on the bonds … makes these contingent claims as well. --> this part was part of the 2009 Mock exam question where the asset side had contingent claims risk.
I think “standard immunization” is another name of “classical immunization”.
When interest rate rises, the fixed-rate assets lose value. When interest rate rises, the return of the floating-rate assets is capped if the floating-rate is capped. This will cause a mismatch of assets and liabilities.