C207: Liability Relative Investing

Key Words and Concepts Durations by Asset Class Surplus Duration

C207: Liability Relative Investing

Key Words and Concepts

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Key Concepts

Key Words and Phrases to Know: Dual-duration matching Surplus duration Ination durations vs. real interest rate durations Liability-relative investing Portfolio optimization Cross-reference with Liability-Relative Strategic Asset Allocation Policies (Study Note V-C127-09)

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Key Words and Concepts

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C207: Liability Relative Investing

Key Words and Concepts Durations by Asset Class Surplus Duration

C207: Liability Relative Investing

Durations by Asset Class

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Durations by Asset Class

Bonds Ination and real interest rate durations are typically the same Equities Real interest rate durations are typically much higher than ination durations TIPS Ination duration is zero; Real interest rate duration is similar that of a comparable nominal bond Liabilities Ination duration is practically zero for COLA, slightly above zero for non-COLA; Real interest rate duration can be quite high

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Durations by Asset Class

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C207: Liability Relative Investing

Key Words and Concepts Durations by Asset Class Surplus Duration

C207: Liability Relative Investing

Surplus Duration

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Surplus Dollar Duration

Ideally surplus duration is zero, which means: ADi,A LDi,L = 0 ADr,A LDr,L = 0 Generalized to a multi-asset class portfolio with 4 unknowns:
T IP S D( r,0),T IP S + N om D(r=i),N om + E D(r,i),E L D(r,i),L = 0 4 unknowns Knowns (or estimates)

If we focus on dollar durations rst, we really only have 2 unknowns:

:0      T IP S Di,T IP S + N om DN om = L Di,L E Di,E 

T IP S Dr,T IP S + N om DN om = L Dr,L E Dr,E

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C207: Liability Relative Investing

Decomposing the Dollar Durations

Rearranging from the previous formulas, the dollar durations are:
N om DN om = L Di,L E Di,E T IP S Dr,T IP S = L Dr,L E Dr,E N om DN om

To get to durations and dollar balances, 1. Assume a reasonable value for the nominal bond duration 2. Calculate the nominal bond and TIPS balance:
 N om  D N om N om =  D  N om T IP S = A E N om

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Pop Quiz Part 1

Dueling Durations, Inc. manages a pension plan with the following characteristics: Plan assets total 10 million Plan liabilities are 9 million Assets are currently split 50/50 between equities and standard xed-income bonds Equities have a dual duration of (20,4) The bonds have a dual duration of (4,4) Liabilities have dual duration of (16,3) Questions: 1. How sensitive is surplus to changes in ination? 2. Changes in real interest rates? 3. What xed-income bond duration would eliminate all surplus sensitivity?
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Solution to Part 1
Surplus ination dollar duration (millions): = E Di,E + N om DN om L Di,L = (5)(0.04) + (5)(0.04) (9)(0.03) = 0.13 million Surplus real dollar duration (millions): = E Dr,E + N om DN om L Dr,L = (5)(0.20) + (5)(0.04) (9)(0.16) = 0.24 million

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Pop Quiz Part 2

DDs CEO walks into your oce and says: Im sick of all this surplus sensitivity, and we really need to add some ination protection to the portolio. If you can do that, Ill let you borrow my Aston Martin this weekend. What dya say? Oh, but just one thing. . . dont you dare mess with the xed-income bond duration! Before you can ask why, he grabs a stful of M&Ms from your candy dishtaking most of themand briskly leaves.

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Solution to Part 2
Solution: We need trade some of the existing xed-income bonds for TIPS. First, lets calculate the xed-income bond balance: N om DN om = L Di,L E Di,E N om 0.04 = (9)(0.03) (5)(0.04) N om = 1.75 million Now, we can calculate the TIPS real dollar duration: T IP S Dr,T IP S = L Dr,L E Dr,E N om DN om = (9)(0.16) (5)(0.20) (1.75)(0.04) = 0.37 million

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Solution to Part 2 (contd)

Since all asset balances have to add up to A: T IP S = A E N om = 10 5 1.75 = 3.25 And so: Dr,T IP S = T IP S Dr,T IP S T IP S 0.37 = = 0.11 3.25

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Solution to Part 2 (contd)

Lets check our solutions:
T IP S Di,T IP S + N om DN om + E Di,E L Di,L = 0

(3.25)(0) + (1.75)(0.04) + (5)(0.04) (9)(0.03) = 0

T IP S Dr,T IP S + N om DN om + E Dr,E L Dr,L = 0

(3.25)(0.11) + (1.75)(0.04) + (5)(0.20) (9)(0.16) = 0

If you could substitute xed-income bonds with a higher duration, what would happen to the required TIPS duration?

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Surplus Duration as a Percentage of the Liability

D(r,i),S (L) =

T IP S D(r,0),T IP S + N om D(r=i),N om + E D(r,i),E D(r,i),L L

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