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55 Cards in this Set
- Front
- Back
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QBS 30: 1 of 56
From an Asset-Liability Context Should consider the following when determining risk tolerance: |
1) Relative size of company's worldwide pensions to sponsor's size
2) Credit rating/strength of sponsor 3) Plan's funded status |
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QBS 30: 2 of 56
From an Asset-Liability Context Types of ALM Strategies |
1) Dedication
2) Immunization 3) Horizon matching 4) Contingent immunization |
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QBS 30: 3 of 56
From an Asset-Liability Context Liability-driven investing (LDI) |
- Can divide the portfolio into two parts:
1) Part that hedges liability risk 2) Part that generates excess return - Maximize return while reducing interest rate risk - Strategy tailored to specific plan needs - Principal measure is the plan's funded status - Investment framework not restricted to just bonds |
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QBS 30: 4 of 56
From an Asset-Liability Context Three key concepts of LDI management |
1) Liability duration must be hedged or partially hedged by the assets
2) Asset duration can come from either securities or from interest rate derivatives 3) Excess return comes at the cost of increased liability tracking risk |
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QBS 30: 5 of 56
From an Asset-Liability Context LDI Checklist |
1) Determine objectives
2) Determine plan liability effective duration 3) Determine desired fixed income allocation 4) Determine portfolio effective duration 5) Determine additional duration needed 6) Determine degree of comfort with derivatives 7) Determine appetite for active management 8) Monitor LDI strategy against liability benchmark |
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QBS 30: 6 of 56
From an Asset-Liability Context Limitations of liability-driven investing |
1) Higher expected long-term return is sacrificed for lower risk
2) Availability of certain types of investments may be limited |
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QBS 30: 7 of 56
From an Asset-Liability Context Two ways to mitigate funded status volatility |
1) Asset diversification
2) Duration management |
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QBS 30: 8 of 56
From an Asset-Liability Context Ways to increase matching if liability duration longer than the asset duration |
1) Adding long-term bonds
2) Replacing short-term bonds with long-term bonds 3) Increasing inflation-linked assets (if the benefits are inflation indexed) 4) Using fixed income derivatives a) Futures b) Forward contracts c) Swaps d) Option strategies i) Swaption ii) Swapcollar |
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QBS 30: 9 of 56
From an Asset-Liability Context Interest Rate Swap |
- A periodic exchange of cash flows
- Have a fixed leg and a floating leg component - Settlement = the annual rate difference x the notional principal x the fraction of the year - Swap duration = difference of duration of fixed rate bond and the duration of the floating-rate bond - Swap duration for fixed-rate received is positive - The same swap has a negative duration for the counterparty |
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QBS 30: 10 of 56
From an Asset-Liability Context Swaption |
- Have right but not the obligation to enter an underlying swap
- Pay an upfront premium - Can set the exercise date to be the plan's next measurement date - A purchased receiver swaption provides protection against yields below strike level |
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QBS 30: 11 of 56
From an Asset-Liability Context Choices swaption receiver has on exercise date |
1) Out-of-the-money: let option expire
2) In-the-money a) Take delivery and become receiver of an above-market swap b) Close out swap and collect FV |
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QBS 30: 12 of 56
From an Asset-Liability Context Swaption collar |
- Plan buys one swaption and sells another
- Buy a fixed rate receiver option - Sell a floating rate player option - Reduces or eliminates up-front expense - Receiver option increases in value if rates drop below strike level - Higher asset offsets increase in liability - Payer option decreases in value if rates increases above strike level - Lower asset offset by decrease in liability |
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QBS 30: 13 of 56
From an Asset-Liability Context Disadvantage of large fixed income allocation |
- Lower expected returns
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QBS 30: 14 of 56
From an Asset-Liability Context Advantage of swaps and swaptions |
- Minimize volatility without changing the asset allocation
- May have higher return than large fixed income strategy |
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QBS 30: 15 of 56
From an Asset-Liability Context Caveats regarding a risk management strategy involving rate derivatives |
1) Significant learning curve
2) Should consider underhedge vs. overhedge 3) Model risk |
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QBS 30: 16 of 56
From an Asset-Liability Context Disadvantages of derivatives |
1) Need sufficient liquidity to fund initial and variation margin requirements
2) Introduces other sources of risk a) Counterparty b) Lquidity c) Valuation d) Tracking |
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QBS 30: 17 of 56
From an Asset-Liability Context Duration |
- Modified duration is the first derivative of the bond with respect to a change in the interest rate
- Amount in percent that a bond is expected to rise/fall due to a 1 percent decrease/increase in interest rates - Weighted average of the time until each cash flow payment, where the weights are equal to the PV of each cash flow - The second derivative is convexity |
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QBS 30: 18 of 56
From an Asset-Liability Context What drives the price component of a bond? |
Change in price = (change in yield) x (duration) x (-1)
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QBS 30: 19 of 56
From an Asset-Liability Context Convexity typically thought of as a percentage measure |
Price gain from convexity = 1/2 x convexity x change in interest rates
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QBS 30: 20 of 56
The Effects of a Plan's Funding Level on Investment Strategies Factors that influence a sponsor's investment objectives and risk tolerance |
1) Systemic elements
2) Idiosyncratic elements |
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QBS 30: 21 of 56
The Effects of a Plan's Funding Level on Investment Strategies Funding status and its effects on investment strategy |
- Benefits and risk associated with being over - or underfunded are asymmetric
- Utility increases as funded status increase but at a decreasing rate |
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QBS 30: 20 of 56
The Effects of a Plan's Funding Level on Investment Strategies Investment decision tree (underfunded and fully funded plans) |
Funded status - Sponsor willing and able to make large contributions - Decision
Underfunded plan - Yes (ideal) - Liability-sensitive approach Underfunded plan - No - Total-return approach (high probability of failure) Fully funded - Yes - Total-return approach Fully funded - No - Liability-sensitive approach |
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QBS 30: 23 of 56
The Effects of a Plan's Funding Level on Investment Strategies Investment decision tree (overfunded plans) |
Plan status - Decision
Frozen - Liability-sensitive approach Active - Liability-sensitive approach if want to manage volatility and maintain funded status Active - Total-return approach if have higher risk tolerance or if prefer higher funded status over managing volatility |
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QBS 30: 24 of 56
Primarily Used from an Asset-Only Context Purpose of risk management |
1) Necessary to drive returns
2) Monitor risk level and its sources ensuring match expectations a) Make sure at target level; don't want too much or too little risk b) Monitor risk/return relative to strategic benchmark 3) Recognize and prepare for all possible future outcomes |
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QBS 30: 25 of 56
Primarily Used from an Asset-Only Context Investment plan components |
1) Asset allocation
a) Tactical b) Strategic 2) Risk budget 3) Update and monitor investment plan |
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QBS 30: 26 of 56
Primarily Used from an Asset-Only Context Asset allocation |
- Determines overall risk level and long-run expected return
- Determine the bond/equity split - Determine allocation to alternative asset classes |
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QBS 30: 27 and 28 of 56
Primarily Used from an Asset-Only Context Risk budget Involves Asset Allocation Decisions Around (1 and 2 of 2) |
1) Benchmarks to use
2) Allocation between passive and active management a) Number of funds to invest in b) Number of mangers to hire c) Percentage of assets to give each manager d) Allocating / balancing active risk of multiple managers e) Level and structure of active risk 3) Choosing different styles of active management 4) Which products to put into portfolio 5) Whether and how to make tactical asset allocation adjustments 6) Hedging foreign currency risk |
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QBS 30: 29 of 56
Primarily Used from an Asset-Only Context Process of updating/monitoring investment plan |
1) Rebalancing portfolio components
2) Review external managers 3) Adjusting investments cash in- and outflows 4) Review risk budget 5) Update strategic asset allocation benchmark 6) Whether to terminate/hire managers |
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QBS 30: 30 of 56
Primarily Used from an Asset-Only Context Strategic allocation |
- Designed to be a stable asset mix that maximizes long-term expected return give a targeted level of risk
- Designed to reflect long-term investment objectives |
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QBS 30: 31 of 56
Primarily Used from an Asset-Only Context Tactical asset allocation |
- Focuses on short-term investment decisions
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QBS 30: 33 of 56
Primarily Used from an Asset-Only Context Standard steps for finding a strategic asset allocation |
1) Determine the relevant asset classes
2) Estimate volatility and correlation returns 3) Project expected returns 4) Find an efficient frontier 5) Select a point on the efficient frontier 6) Evaluate the portfolio structure 7) Set constraints and reoptimize/go to step 1 start process again |
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QBS 30: 34 of 56
Primarily Used from an Asset-Only Context Disadvantages of standard approach |
1) Extreme optimal weights
a) May lead to imprudent weights b) Hard to develop intuition behind the portfolio c) Does not allow consistent advice giving 2) Optimal weights sensitive expected return assumptions a) Expected return assumptions sensitive to time period data gathered |
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QBS 30: 35 of 56
Primarily Used from an Asset-Only Context Advantages of the equilibrium approach over the standard approach |
1) More theoretically correct neutral point
2) Relies more on volatility vs. return measures 3) Easier to identify and understand key trade-offs 4) Easy to implement 5) Portable across clientele types |
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QBS 30: 36 of 56
Primarily Used from an Asset-Only Context Risk dimensions include |
1) Market risk
2) Credit risk 3) Legal risk 4) Operational risk 5) Liquidity risk |
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QBS 30: 37 of 56
Primarily Used from an Asset-Only Context Risk management tools |
1) Value at Risk (VaR)
2) Annualized volatility a) No portfolio change: measure historic volatility b) Portfolio changed: disaggregated approach 3) Annualized tracking error 4) Stress test 5) Scenario analysis |
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QBS 30: 38 of 56
Primarily Used from an Asset-Only Context VaR |
- Measures the size of the loss that is expected to occur with a specified frequency
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QBS 30: 39 of 56
Primarily Used from an Asset-Only Context Stress test |
- Identify a dimension of risk
- Analyze shock along dimension - Estimate change in value |
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QBS 30: 40 of 56
Primarily Used from an Asset-Only Context Stress test limitations |
1) Likelihood of shocks not provided
2) Likelihood of different market correlation not provided |
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QBS 30: 41 of 56
Primarily Used from an Asset-Only Context Advantages of scenario analysis |
1) Represents likely risk
2) Good for preparing for a particular outcome |
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QBS 30: 42 of 56
Primarily Used from an Asset-Only Context Disadvantages of scenario analysis |
1) Hard to know which scenarios to analyze
2) Hard to know how to react 3) Difficult to put probabilities on scenarios 4) Difficult to approximate all possible scenarios with a few scenarios |
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QBS 30: 43 of 56
Primarily Used from an Asset-Only Context Advantage of the volatility risk measure |
1) Summarizes many possible outcomes in one number
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QBS 30: 44 of 56
Primarily Used from an Asset-Only Context Disadvantages of the volatility risk measure |
1) Tries to capture risk in one number
2) Upside vs. downside risk not distinguished 3) Sources of risk not provided 4) Inadequate when decisions driven by limiting losses below certain size |
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QBS 30: 45 of 56
Primarily Used from an Asset-Only Context Disaggregated approach |
1) Use stress test to different risk sensitivities
2) Then estimate covariance structure of risk factors a) Creates a probability distribution for risk factors 3) A distribution is implied for portfolio valuations 4) Measure volatility of that distribution |
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QBS 30: 46 of 56
Primarily Used from an Asset-Only Context Volatility measures okay |
1) Returns aggregated over long periods of time
2) When options/derivatives not used |
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QBS 30: 47 of 56
Primarily Used from an Asset-Only Context Best way to understand sources of risk |
- Portfolio risk decomposition
- Estimate impact of change in weights on portfolio risk |
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QBS 30: 48 of 56
Primarily Used from an Asset-Only Context Investor utility and its reflection on optimal portfolio development |
- Look at intersection of efficient frontier and utility curve
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QBS 30: 49 of 56
Primarily Used from an Asset-Only Context Other types of risk management investment strategies |
1) Alternative investments
a) Private equity b) Hedge funds c) Commodities d) Infrastructure 2) Alpha-only portfolio |
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QBS 30: 32 of 56
Primarily Used from an Asset-Only Context Approaches to determining strategic asset allocation |
1) Standard
2) Equilibrium |
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QBS 30: 50 of 56
Primarily Used from an Asset-Only Context Risk management examples of alternative investment strategies |
1) infrastructure assets and private equity match long-term liability characteristics
2) Can hedge inflationary benefit increases with commodities and many infrastructure assets 3) Alternative assets have a low correlation with stocks and bonds |
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QBS 30: 51 of 56
Primarily Used from an Asset-Only Context Potential pitfalls and challenges of alternative investments |
1) Valuation and performance measurements difficult
2) Leveraging used 3) Short histories and a lack of robust data 4) High costs 5) Less control |
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QBS 30: 52 of 56
Primarily Used from an Asset-Only Context Risk management examples of alpha-only portfolios |
1) Can hire a skilled manager that invests in a market deemed to be too risky
2) Return correlation can be measured against other alpha and beta portfolios |
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QBS 30: 53 of 56
Primarily Used from an Asset-Only Context Change in Asset Allocation Risk |
1) Drift
2) Undeployed cash 3) Currency deviations 4) Manger or benchmark transitions |
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QBS 30: 54 of 56
Primarily Used from an Asset-Only Context Ways to Minimize Allocation Risk |
1) Rebalancing
2) Completion manager |
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QBS 30: 55 of 56
Investment Management Process - IPS (Forces countering risk management strategies) Effectiveness of ALM strategy can be reduced by* |
1) Payment amount uncertainty
2) Timing of payment uncertainty * both of these uncertainties can exist not only on the liability side but also the asset side (e.g. default risk, risk of bond being called, etc.) |
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QBS 30: 56 of 56
Investment Management Process - IPS (Forces countering risk management strategies) Events that cause change in duration and method for keeping duration on track |
- Change caused by
1) Yield curve changes 2) Passage of time - Rebalancing required |
