Hello, I have a question on surplus optimization:
“The observed relationship that the allocation to corporate bonds declines with increasing surplus return can be explained by the positive correlation of bond price with the PV of liabilities” ==> I am struggling to understand this sentence.
What do corporate bonds represent in a surplus optimization context? And why is cash almost omitted here when dealing with the most conservative asset allocation?
The corporate bonds have been assumed to have same risk and returns attributes as liabilities. Increase in surplus gives to confidence and allows PM to take more exposure to more risky assets hence corporate bonds are zero when you move to right.
The cash is omitted at conservative AA because keeping cash in hand won’t generate the required return to meet liability unless you allocate funds to risky assets (higher Std deviation), which is less preferred strategy when PM is not keen to make cash contribution.