This is Relative Value Methodologies, for Global Credit: Couldn’t Statement #2 be incorrect, if duration of liabilities exceeds that of assets? Meaning, a downward movement in rates lowers your cushion? Thanks
Not seen the question, but IMO : Cushion = PV of assets - PV liabilities if duration of liabilities exceed that of assets, For a downward movement in rates --> PV of liabilities will increase more than PV of assets --> reduction in cushion.
See CFA text chapter 28, pgs 36-37 for an explanation as to why the dollar safety margin increases when interest rates decrease. To summarize, contingent immunization doesn’t contemplate a change to the liability amount when interest rates change. I had the same question when I first did the problem. I think it’s a bad question overall because of the issues you raised.
Don’t have the text book book with me at the moment but would try to explain from what I retain: Initial cushion is determined based on MV of bond (say 20 year bond) held to meet the liability (say due after 3 years), subtracted by PV of liability based on a given yield Going forward if given yield declines, MV of bond will increase much more (due to longer duration) than than PV of liability thus cushion will increase
Also, what about Question 26. OAS excludes the option - i.e the prepayment risk ; but it doesn’t exclude default risk. Am I missing something?
OAS can be viewed as the compensation an investor receives for assuming a variety of risks (e.g. liquidity premium, default risk, model risk), net of the cost of any embedded options. OAS is the spread over Risk Free rate for bearing risks -liqudity, default and model risk. However, it is adjusted for embedded options, such as prepayment, call etc.
rp77, why do you use 20 year bond? Isn’t it an immunization portfolio having same duration as the liability? I am not sure what your context was.
lzhao Wrote: ------------------------------------------------------- > rp77, > > why do you use 20 year bond? Isn’t it an > immunization portfolio having same duration as the > liability? I am not sure what your context was. No I wouldn’t. To immunise for one time change in interest rates, rather I would attempt to minimise risk by matching duration and PV of cashflows of assets and liabilities. 20 year bond to explain the risk the position may carry.