Could someone please explain why the following two statements hold?
If the manager believes rates will increase, underhedge (<100%) and the losses on the contracts will be reduced, improving portfolio performance and increasing the surplus.
reduce the hedge size, leaving the BPV of assets less than of a fully hedged duration gap.
Leaving the BPV of assets at a lower level means they will decline less as interest rates rise. - Why?
If the manager believes rates will decrease, overhedge (>100%) and the gains on the contracts will be increased, improving portfolio performance and increasing the surplus
decrease will increase the hedge size, increasing the BPV of assets above that of a fully hedged duration gap.
Increasing the BPV of assets means they will increase in value more as interest rates decrease. - Why?
Should heading be always 100% ? 100% hedging will cap any upside potential
Basis Point Value ( BPV) is Duration expressed in absolute terms.
If rates increase you would want a higher Abs. Higher Dur. Or a lower one ( wrt the Liability BPV)?
If rates decrease, you would want to take advantage of the situation and thus overhedge the asset side and thereby want to have a higher absolute dur or a lower one ( wrt the Liability BPV) ?
Both choices if exercised, will improve your surplus
So… to your questions (not sure if they were rhetorical, though :D)
A. If rates increase, and my value decreases, I´d want a lower duration for my assets, so that they decline less.
B. If rates decrease, and my value increases, I´d want a higher duration for my assets, so that they increase more… so that´s why you overhedge, to “magnify” the duration effect?