Given that a pension fund has a benchmark with duration 5.6 and the portfolio duration is 6.2. The duration of the liability if 10.2, which of the term structure interest rates and the duration mismatch between the benchmark and its pension liability would the plan be most concerned?
A) Flattening of the yield curve;
B) Steepening of yeidl curve;
C) Large parallel shift up in the yield
The answer is A. Could you please explain? Isn’t that the flattening yield curve meaning the rise in short term interest rate and fall in long-term interest rate? If this is so, the decrease in liability should be larger than decrease in asset(portfolio) value in short-term since it has a greater duration. Hence, it should not be a concern.
Or should the emphasis be placed on the move of the long-term interest rate since it is a pension fund?
Additionally, for fully funding liabilities utilizing a standard immunization approach with non-callable bonds, why the risk associated with the liabilities include “contingent claim risk”?
You may refer to the after-chapter exercise “EPF Portfolio” for CFA textbook under “Fixed Income Portfolio Mnaagement Part II”. Thanks.
3 possible flattening scenarios 1) The short rates move up a lot and the long end moves up a little. In this case, the shorter duration will be more affected than the longer duration. i.e. the asset yields move up more than the liabilities causing asset value to drop more than liabilities. 2) The short rates move up and the lond end moves down In this case, the shorter duration loses value due to higher yields and the longer duration face decreasing yields which means higher liabilities. 3) The short rates decrease a little and the long rates decreases more In this case, the short end rates decrease which increases the value of assets but the longer rates decrease more increasing the value of the longer duration liabilities more than the assets.
In all the situations they face either lower assets or higher liabs or a combo of both. The 2nd question has been discussed before and the general consensus is that the question is referring to the overall general risks associated with liabs and not the ones specific to the situation. It’s a bad questions in my opinion.
Hi Kato, thanks for your clarification. For 1), I don’t understand why the shorter duration will be more affected than that of longer duration, given that the short-term / long-term rates moving up. Won’t the liabilities decrease more than the asset in both the short-term rate moving up and the long end moving up, since it has a larger duration?
For the curve to flatten in scenario 1-- the short end would have to move up more than the longer end. Keep in mind duration measures the sensitivity to parallel shifts in the yield curve and this is not a parallel shift. The thing to realize is that the longer duration on the liabs means that they have a longer avge maturity. This would cause a larger rate increase in the short-end(a deeper drop in your shorter term assets value --short-end is more volatile) than it would for your longer maturity liabs.
So they both decrease in value but the shorter term assets decrease more because the shorter rates have to increase more for the curve to flatten.