Structural Risk

CFA Level III
#1

Some questions:

  1. Structural risk is to do with dispersion of CF right? So high dispersion = high structural risk?

  2. If we want to reduce structural risk, what can we do?

Move from Barbell to bullet to reduce dispersion…What else?

  1. Does high convexity mean high structural risk?

  2. If we are choosing a bond to immunise single liability we want lowest Convexity of the choices. If we immunise multiple liability, we want highest convexity of the choices - Are these statements correct?

Thanks

#2

  1. Almost correct. It’s the risk where yield curve changes impact _ cash flow and its yield _ which will impact immunization.

  2. You can do a “perfect immunization” which is to use zero-coupon bonds which mature at the date of each liability due with face value equal to face value of the liability. However, such bonds may not exist in the market and there’s always risk of default.

  3. To some extent, yes. Higher convexity means higher duration change when yields change.

  4. Yes, according to the curriculum. The rationale for picking a high convexity portfolio in multiple liability matching is due to high convexity portfolio allow greater price gain when interest rate decreases compared to a low convexity portfolio. Furthermore, high convexity portfolio also produce lower price loss when interest rate increases due to this formula we learned back in Level 1:

ΔV= −DΔy + 0.5C(Δy)2

(Δy)2 is always positive since it is a squared term.

Now, as to why this rationale does not apply to a single liability scenario is what confuses me. I think it’s a trade-off thing.

2 Likes
#3

I’m on bonds this week :slight_smile:

Checked the curriculum on immunising single vs multiple liabilities.

You always want to minimise convexity, but with the constraint that the convexity must be higher than that of the liability (liabilities) you are trying to immunise.

Reading 22, section 4.2, example 4, penultimate and final paragraphs of solution to question 2,

My greedy side wonders why we wouldn’t want to grab a little extra convexity when immunising - surely we could use the extra convexity gains to offset future immunisation trading expenses (or buy me a nice celebratory lunch). I suppose you are trading higher convexity for a lower yield, so you need to minimise convexity in order to minimise the price you pay for the immunisation…

#4

With convexity, it’s important to know whether you’re immunizing or using active management. I agree with you guys regarding minimizing convexity for a single liability (assuming the client wants to reduce the structural risk), but in active management, if you believe volatility will increase, adding convexity enhances returns for a decrease in interest rates and dampens losses when rates rise

#5

The big picture they are trying to teach us in L3 is that convexity isn’t a free lunch in active management.