Comment with regards to offsetting price and reinvestment risk when:
Duration of Assets < Duration of Liabilities and interest rates are flattening.
Duration of Assets > Duration of Liabilities and interest rates are sloping upwards.
Solution:
The assets are maturing before the liability dates. The assets bond value is less sensitive to interest rate changes than the liabilities. The losses from the reinvestment income > the gains from bond value and therefore reinvestment risk is a concern.
The assets are maturing after the liability dates. The assets maturing bond value is more sensitive to interest rate changes than the liabilities. The loss in value of bond > gain in reinvestment income and therefore price risk is a concern.
This is not from any textbook but taken from the forms. Does this logic seem correct? What about the case for a) if the interest rates are sloping up? Would that mean the loss in value of the bond < gain in the reinvestment income and therefore, NO risk is apparent?
Funding pension liabilities with 1 year bonds. (liability duration > asset duration)
As interest rates drop, the pension liabilities will jump up while the assets will be relatively stable and reinvestment income will drop like a stone. That’s why pension funds and life insurers love long-term bonds!
Mortgage loans funded with 1 year bonds (asset duration > liability duration)
As interest rates rise, the mortgage assets drop, while the liability remains relatively stable and interest expense rises. Newcourt Credit experienced this situation way back when.
Since the duration of liabilities is greater than the assets, it will experience a greater price increase than the assets. To meet these liabilities, reinvestment of assets is a concern now that interest rates have flattened to meet the increased liability.
I just skimmed what you wrote – I’ve been busier than a one-armed paper-hanger this semester – and the first thing that struck me was that you may be conflating duration with maturity. For example, if your assets have a shorter (effective) duration than your liabilities, it doesn’t necessarily mean that your assets will mature before your liabilities. For example, you could have all 10-year floating-rate assets (very short effective duration: roughly ½ the time between coupon payments ), and all 5-year fixed-rate liabilities (with effective durations of 4.5 years or so).
Aside from the duration component (remove the comment assets are maturing before/after liability dates for both parts, then does the logic make sense)?
