interest rate risk, contingent claim risk and cap risk are the risks a manager should be concerned about WITH REGARDS TO PAYMENTS OF LIABILITIES. It does not matter how those liabilities are being financed on the side with assets.
Interest Rate Risk: Rate rises - due to a duration mismatch between assets and liabilties - the liabilties become harder to pay.
Contingent Claim Risk: is a risk when rates fall. MBS and other securities with embedded call options which are present in your liabilties portfolio may require to be paid immediately (due to refinancing).
Cap Risk: When rates rise - an asset that is present in your portfolio to meet liabilites schedules may get capped - and hence your assets are not present in enough quantity to pay your liabilities.
It is not the assets ( his non-callable bonds ) that are subect to contingent claims risk.
It is the liabilities.
For example the funding for the new wing may have been partially through putable bond issues , which could be put back to the pension fund at a time when rates are rising , thus increasing future liability costs
Yes, the vignette clearly states that the manager is concerned about all 3 risks with regards to liabilities. I did give it some serious thought before posing the question.
But, this is a pension fund and there should not be any MBS on the liabilities side, only on the assets side, if any. I guess you are talking about other pension liabilities that might need to be paid off immediately if the interest rate goes down? If you would elaborate, I surely will appreciate.
These risks (interest rate, contingent claim, and cap risks) are that the assets are insuffucient to fund the liability. So this could come from either side of the equation (Higher Liabilities OR Lower Assets).
For interest rate risk it could mean a mismatch of duration. If int rates go up risk is that duration of liabilities is lower than that of assets, or if int rates go down risk is that duration of liabilities is higher than that of assets. For contingent claim risk it could mean HOLDING callable bonds or MBS type securities; or ISSUING puttable bonds. And cap risk could mean holding a floater that is capped on the upside, or issuing a floater with a floor - right?
I am trying to understand this: Wouldn’t change in int rates affect the duration of both liabliities and assets in the same direction?
"For interest rate risk it could mean a mismatch of duration. If int rates go up risk is that duration of liabilities is lower than that of assets, or if int rates go down risk is that duration of liabilities is higher than that of assets. "
duration is assumed constant . It is assumed not to change. The direction of exposure change is the same between assets and liabilities . For instance if rates drop assets increase in value while liabilities also increases in value . But you have a negative sign in front of liabilities ( to the pension fund )
Here we’re talking of liabilities which has a higher duration than the benchmark. So a drop in rates is going to increase liabilities value more than the benchmark increase . So youre only making the net ALM gap wider.
esandun: even though the pension fund is fully funded today , the obligations of the fund still lay a claim on the assets of the corporation . This is modeled with put and call options on the various asset components of the corporation . For example future funding for the pension is hugely contingent on the continued strength of the fund sponsor as well as the leverage in the sponsor balance sheet ( i.e. the debt they acquire ). Any model that tries to derive a discount rate for the pension liabilities definitely makes path dependent assumptions for the variables that drive the sponsor’s financial health
Just because currently the fund is fully funded does not mean that they are free to declare independence from the sponsoring firm for future unmet obligations . Actuarial numbers for liabilities have built in assumptions too which can be modeled with probabilities .options probably are the best market model representation of risky assets and risky liabilities . All options come loaded with contingent claims.
This question is not about a pension fund. But about a hospital project which is fully funded. Not like pension funds (DBs) there no indication of possible future liabilities beyond immunization (thhis is a on -off situation).
As I have stated above post, the question clearly say only non-callable bonds are there.
Thanks for the reply, however your reply is out of focus, IMHO.
OK I assumed the hospital was funded by the pension fund , but they have not made the connection .
However the hospital’s projects could be funded with loans:
" local hospital, which is currently fully funded utilizing a standard immunization approach with non- callable bonds" . Doesn’t mean that the bonds are also not putable by the lenders to the hospital.
If the loans are put back to the hospital by lenders when rates rise , that would be a contingent claims risk.