Pavonia Case - LDI - Interest Rate Hedging - CFAI Mock

CFA Level III Derivatives
#1

||Lawson|Wharton|
|Market value of assets|USD15,498,000|USD8,351,000|
|Duration of assets|7.79|7.82|
|Duration of liabilities|7.78|10.01|
|Semiannual portfolio dispersion|46.07|147.22|
|Accumulated benefit obligation|USD14,389,000 USD7,470,000

Adams states to Neeson, “For the Lawson and Wharton plans, we can consider one of three alternative strategies to manage the multiple liabilities associated with these plans. Whenever a plan’s surplus is less than 5%, we favor passive management strategies. We could also use a derivatives strategy, and I prefer derivatives strategies that protect the portfolio against an increase in interest rates but will not produce large losses if rates decrease.”

Q. Which of the following strategies most likely meets Adams’ preferences?

  1. Buy a payer swaption.
  2. Write a receiver swaption.
  3. Enter into a pay fixed swap

I am so confused: If IR increase 5%, you prefer Pay Swpn [X=4% say]; IR dec or 2%, you prefer Rcvr Swpn, same strike;

Is the answer addressing contingency for IR increase or decrease? Apparently for increase, in case it decreases, how is the answer going to help prevent large losses

I am totally lost so I may be completely wrong - so please help me with my confusion if possible?

#2

They’re looking for an approach with upside when rates increase and no downside when rates decrease.

Buying a payer swaption has upside when rates increase and no downside when rates decrease.

Writing a receiver swaption has downside when rates decrease and no upside when rates increase.

Entering into a pay fixed swap has upside when rates increase and downside when rates decrease.

#3

Thank you S2k.

So when they refer to “strategy… to prevent large losses”, they are not necessarily implying that the “purchase of payer swaption” is going to help in some form such as a pay off in loss situation. It is that the derivative itself does not add to ‘any losses’ the portfolio might incur in a IR decrease scenario

For example say IR decrease by 1%, A=9M; L=8.2M; Payer OTM=Not exercised
increase 1%; A=7.7M; L=6.7M; Purchased Payer swaption ITM and exercisable

Could you please help if my understanding is accurate?

#4

That’s exactly what they’re saying.

If interest rates rise, they expect a large loss in the sense that the value of their assets will decrease by almost twice the decrease in the value of the liabilities. If they buy a payer swaption, they can exercise the swaption and receive a positive (net) payment from the ensuing swap, which will help cover the loss.

#5

So my confusion is that I guess I am reading too much into the text. The above text to me associates “large losses” with rates decrease, which apparently is never the case ie any durational asset will gain value.

But if I understand the way you worded it, it makes sense.

Correct me if I am wrong, otherwise, thanks a lot.

#6

True, but depending on the size and duration of the assets vs. the liabilities, a pension plan could lose (net) value if rates decrease; e.g., when the money duration of assets is less than the money duration of the liabilities.

#7

Thank you so much S2K. This helps. I guess I am reading “will not produce large losses” as “will prevent large losses” - my bad - thx again

#8

My pleasure.