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Up1
Q23. Salvatore Choo, the Chief Investment Officer at European Pension Fund (EPF), wishes to maintain the fixed-income portfolio’s active management but recognizes that the portfolio must remain fully funded. The portfolio is run by World Asset Management, where Jimmy Ferragamo, a risk manager, is analyzing the portfolio (shown in Exhibit 1), whose benchmark has a duration of 5.6. None of the bonds in the portfolio have embedded options. However, EPF’s liability has a duration of 10.2, creating an asset liability mismatch for the pension fund.”
Given the term structure of interest rates and the duration mismatch between EPF’s benchmark and its pension liability, the plan should be most concerned about a:
A flattening of the yield curve.
B steepening of the yield curve.
C large parallel shift up in the yield curve.Answer: A is correct. Given the mismatch in the liability and the benchmark they are running against, a flattening of the yield curve would cause the liability to increase faster than the asset.
Can someone explain the answer to me please. I don’t quite get it. I understand that if short term rate comes down then the liability obligation will increase. But why a flattening of the yield curve?
Thanks!
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Up2
@alta12, just adding to @RaviVooda‌ ‘s explanation: this question is testing to your understanding of duration gap and our need to understanding the impact on asset and liability.
This is especially relevant for pension funds as their goal is to minimize asset liability mismatch and more importantly not get into deficit ( pension asset< pension liability). Pension funds have the classic problem of trying to match SHORT TERM asset returns with LONG TERM liability. In this case, asset duration is less than liability's duration - meaning that changes in interest rates affect liability more than assets. So the worst thing to happen to EPF is if the long term interest rates go DOWN (increasing LT liability) and short term interest rates go UP (reducing asset value), I.e. flattening of the yield curve ==> deficit increases significantly.
Hope this is clear! Let us know if you have further questions!
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Up2
@ravivooda @sophie Got it guys! Thank you 🙂
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Up1
@Alta12, In flattening when the long term interest rates come down, the liabilities go up drastically than the short term ones because of its higher duration there by creating a larger mismatch between assets and liabilities. Hence manager should be more concerned here.
In steepening, where short term interest rates are going down, causes the assets values to go up, there by decreasing gap between assets and liabilities which manager will be happy about.
Hope this helps.
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