Derivatives overlay -Please Help!

CFA Level III Fixed Income
#1

Reference page 73, Volume 4 Cfa Curriculum

“The BPV of the immunizing asset portfolio decreases from EUR 117,824 to EUR 108,679, a drop of EUR 9,145. The BPV for the debt liabilities goes down to EUR 109,278, a drop of EUR 8,546. There is now a duration gap of –EUR 599 (= EUR 108,679 – EUR 109,278). The asset manager could sell some of the 1%, 1.5-year bonds and buy some more of the 4.50%, 11-year bonds to close the money duration gap. A more efficient and lower-cost rebalancing strategy, however, is likely to buy, or go long, a few interest rate futures contracts to rebalance the portfolio.”

Guys i have a few questions;

1, How can a negative duration gap be improved by selling 1.5 year bonds and buying 11 years one as mentioned in the paragraph.

  1. How can going long on interest rate future contacts help to rebalance the portfolio.

Can someone please explain this to me in detail so that i can build my concepts and link them all.

Thanks.

#2
  1. When Asset BPV < Liability BPV, and the Swap market rate is low, then entering into a receive fixed interest rate Swap (going long on interest rate swap) will help buff up the portfolio duration which thus offset the higher liability BPV.

This is covered under LOS 22d,- Fixed Income, Liability Driven Investing.

Waiting for others explanation on No. 1.

#3
  1. I think it can be reasoned in this manner. The 1.5 year bond will obviously have a lower duration when compared to a 11 years bond. Thus selling 1.5 yrs bond and buying 11 yrs bond will increase portfolio duration.
#4

Makes sense. Thanks.

Still don’t get the second part’s answer, but i guess will have go through LOS 22d to get a hold of it.

#5

When the Swap market rate is low, receiving fixed interest payment which is greater than the lower Swap market rate will increase Asset BPV which will thus neutralize the initial higher Liability BPV

#6

Sorry but one more thing. How conceptually will the higher fixed rates be able increase the asset BPV

#7

See it from this angle.

Because most pension fund invest larger portion of their asset in equity (equity generally have lower effective duration) which thus reduce the overall duration of the asset against the liability duration. This leads to negative duration gap, mostly represented in Basis Point Value (BPV).

In order to improve the BPV of asset, we can use Interest Rate Swap Derivative Overlay by going long (receiving the fixed rate) when the interest rate is projected to decline (increase in asset BPV.is always lower than the increase Liability BPV when interest rate decline, and the opposite when interest rate increases).

To improve Asset BPV, we buy the Receiver Swaption which is synonymous to buying a Fixed Rate Bond and issuing a Floating Rate Note (FRN) to finance the purchase of the bond. The effective duration of the FRB > FRN, so you end up with positive Net positive duration which thus improve your asset BPV.

When interest rate is higher, the decline in Asset BPV will be lower than the decline in Liability BPV, so your asset will perform better. In this instance, you can reduce the level of hedge you are using in the portfolio because the asset are performing better than the liabilities.

Hope that helps.

#8

Thanks a lot brother, you couldn’t have explained it any better. Now finally i get the concept. Thanks again. :slight_smile: