ch24 2006

CHAPTER 24
LIABILITY FUND STRATEGIES
CHAPTER SUMMARY
In this chapter we describe basic principles underlying the management of assets relative to
liabilities, popularly referred to as asset/liability management. We also explain several structured
portfolio strategies, strategies that seek to match the performance of a predetermined benchmark.
Finally, we discuss liability funding strategies that select assets so that cash flows will equal or
exceed the client’s obligations.
GENERAL PRINCIPLES OF ASSET/LIABILITY MANAGEMENT
The nature of an institutional investor’s liabilities will dictate the investment strategy it will
request its money manager to pursue.
Classification of Liabilities
A liability is a cash outlay that must be made at a specific time to satisfy the contractual terms of
an issued obligation. An institutional investor is concerned with both the amount and timing of
liabilities because its assets must produce the cash to meet any payments it has promised to make
in a timely way.
The descriptions of cash outlays as either known or uncertain are undoubtedly broad. When we
refer to a cash outlay as being uncertain, we do not mean that it cannot be predicted. There are
some liabilities for which “law of large numbers” makes it easier to predict the timing and/or
amount of cash outlays.
A type I liability is one for which both the amount and timing of the liabilities are known with
certainty. Type I liabilities, however, are not limited to depository institutions. A major product
sold by life insurance companies is a guaranteed investment contract, popularly referred to as
a GIC.
A type II liability is one for which the amount of cash outlay is known but the timing of the cash
outlay is uncertain. The most obvious example of a type II liability is a life insurance policy.
A type III liability is one for which the timing of the cash outlay is known but the amount is
uncertain. A two-year floating-rate CD in which the interest rate resets quarterly based on a
market interest rate is an example.
A type IV liability is one in which there is uncertainty as to both the amount and timing of the
cash outlay. Probably the most obvious examples are insurance policies issued by property and
casualty insurance companies.
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Liquidity Concerns
Because of uncertainty about the timing and/or the amount of the cash outlays, an institution
must be prepared to have sufficient cash to satisfy its obligations. Also keep in mind that the
entity that holds the obligation against the institution may have the right to change the nature of
the obligation, perhaps incurring a penalty.
In addition to uncertainty about the timing and amount of the cash outlays and the potential for
the depositor or policyholder to withdraw cash early or borrow against a policy, an institution has
to be concerned with possible reduction in cash inflows. In the case of a depository institution,
this means the inability to obtain deposits.
Surplus Management
The two goals of a financial institution are to earn an adequate return on funds invested, and to
maintain a comfortable surplus of assets beyond liabilities. The task of managing funds of a
financial institution to accomplish these goals is referred to as asset/liability management or
surplus management.
Institutions may calculate three types of surpluses: economic, accounting, and regulatory. The
method of valuing assets and liabilities greatly affects the apparent health of a financial
institution. Unrealistic valuation, although allowable under accounting procedures and
regulations, is not sound investment practice.
The economic surplus of any entity is the difference between the market value of all its assets
and the market value of its liabilities; that is,
the economic surplus can be expressed as
economic surplus = market value of assets – present value of liabilities.
If interest rates rise, both the assets and liabilities decline, so the economic surplus can increase,
decrease, or not change. If the duration of the assets is greater than the duration of the liabilities,
the economic surplus will increase if interest rates fall. The net effect on the surplus depends on
the duration or interest-rate sensitivity of the assets and liabilities, so it is imperative that
portfolio managers be able to measure this sensitivity for all assets and liabilities accurately.
Accounting surplus is surplus of assets over liabilities as reported in financial statements based
on generally accepted accounting principles (GAAP). Institutional investors must prepare
periodic financial statements that include the reporting of assets and liabilities. With respect to
the financial reporting of assets, there are three possible methods for reporting: amortized cost or
historical cost, market value, or the lower of cost or market value. FASB 115 specifies which of
these three methods must be followed for assets. Specifically, the accounting treatment required
for a security depends on how the security is classified. There are three classifications of
investment accounts: held to maturity, available for sale, and trading.
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The held-to-maturity account includes assets that the institution plans to hold until they mature.
An asset is classified as in the available-for-sale account if the institution does not have the
ability to hold the asset to maturity or intends to sell it. An asset that is acquired for the purpose
of earning a short-term trading profit from market movements is classified in the trading
account. For all assets in the available-for-sale and trading accounts, market value accounting is
used.
Institutional investors that are regulated at the state or federal levels must provide financial
reports to regulators based on regulatory accounting principles (RAP). The surplus as measured
using RAP accounting, called regulatory surplus, may, as in the case of accounting surplus,
differ materially from economic surplus.
IMMUNIZATION OF A PORTFOLIO TO SATISFY A SINGLE LIABILITY
An immunization strategy refers to the investment of the assets in such a way that the existing
business is immune to a general change in the rate of interest.
Investing in a coupon bond with a yield to maturity equal to the target yield and a maturity equal
to the investment horizon does not assure that a portfolio’s target accumulated value will be
achieved. This is because an increase in the market yield causes the market value to fall and the
portfolio can fail to achieve the target accumulated value. This occurs when the fall in principal
is greater than any increase in reinvestment rate. In other words the interest rate (or price) risk
has a greater impact that the reinvestment risk. To avoid this loss (and immunize its portfolio
from interest rate changes), the portfolio manager should look for a coupon bond so that however
the market yield changes, the change in the interest on interest will be offset by the change in the
price.
Consider, for example, an eight-year 10.125% coupon bond selling at 88.20262 to yield 12.5%.
Suppose that $10,000,000 of par value of this bond is purchased for $8,820,262. For this bond, it
can be shown that the accumulated value and the total return are never less than the target
accumulated value and the target yield. Thus the target accumulated value is assured regardless
of what happens to the market yield. For this situation, the coupon issue has the same duration as
the liability.
The equality of the duration of the asset and the duration of the liability is the key to
immunization. When generalizing this observation to portfolios, the key is to immunize a
portfolio’s target accumulated value (target yield). To do this, a portfolio manager must construct
a bond portfolio such that the duration of the portfolio is equal to the duration of the liability, and
the present value of the cash flow from the portfolio equals to the present value of the future
liability.
Rebalancing an Immunized Portfolio
The principles underlying immunization need not just assume a one-time instantaneous change in
the market yield. Even in the face of changing market yields, a portfolio can be immunized if it is
rebalanced periodically so that its duration is equal to the duration of the liability’s remaining
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time. On the one hand, the more frequent rebalancing increases transactions costs, thereby
reducing the likelihood of achieving the target yield. On the other hand, less frequent rebalancing
will result in the duration wandering from the target duration, which will also reduce the
likelihood of achieving the target yield.
Immunization Risk
The sufficient condition for the immunization of a single liability is that the duration of the
portfolio be equal to the duration of the liability. However, a portfolio will be immunized against
interest-rate changes only if the yield curve is flat and any changes in the yield curve are parallel
changes (i.e., interest rates move either up or down by the same number of basis points for all
maturities).
Immunization risk is the risk of reinvestment. The portfolio that has the least reinvestment risk
will have the least immunization risk. When there is a high dispersion of cash flows around the
liability due date, the portfolio is exposed to high reinvestment risk. When the cash flows are
concentrated around the liability due date, as in the case of the bullet portfolio, the portfolio is
subject to low reinvestment risk.
Researchers have developed a measure of immunization risk, which demonstrates that if the
yield curve shifts in any arbitrary way, the relative change in the portfolio value will depend on
the product of two terms. The first term depends solely on the characteristics of the investment
portfolio. The second term is a function of interest-rate movement only. The second term
characterizes the nature of the change in the shape of the yield curve. Because that change will
be impossible to predict a priori, it is not possible to control for it. The first term, however, can
be controlled for when constructing the immunized portfolio because it depends solely on the
composition of the portfolio. This first term, then, is a measure of risk for immunized portfolios
and is equal to
CF1 ( 1 - H ) CF2 ( 2 - H ) CFn ( n - H )

2 2 2
+ + ... +
1+ y ( 1+ y ) 2 ( 1+ y) n
where CFt = cash flow of the portfolio at time period t, H = length (in years) of the investment
horizon or liability due date, y = yield for the portfolio, and n = time to receipt of the last cash
flow.
The objective in constructing an immunized portfolio is to match the portfolio’s duration to the
liability’s duration and select the portfolio that minimizes the immunization risk. The
immunization risk measure can be used to construct approximate confidence intervals for the
target yield and the target accumulated value.
Zero-Coupon Bonds and Immunization
An alternative approach to immunizing a portfolio against changes in the market yield is to

invest in zero-coupon bonds with a maturity equal to the investment horizon. This is consistent
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with the basic principle of immunization, because the duration of a zero-coupon bond is equal to
the liability’s duration. However, in practice, the yield on zero-coupon bonds is typically lower
than the yield on coupon bonds making this strategy more costly.
Credit Risk and the Target Yield
The target yield may not be achieved if any of the bonds in the portfolio default or decrease in
value because of credit quality deterioration.
Call Risk
When the universe of acceptable issues includes corporate bonds, the target yield may be
jeopardized if a callable issue is included that is subsequently called. Call risk can be avoided by
restricting the universe of acceptable bonds to noncallable bonds and deep-discount callable
bonds.
Constructing the Immunized Portfolio
When the universe of acceptable issues is established and any constraints are imposed, the
portfolio manager has a large number of possible securities from which to construct an initial
immunized portfolio and from which to select to rebalance an immunized portfolio. An objective
function can be specified, and a portfolio that optimizes the objective function using
mathematical programming tools can be determined.
Contingent Immunization
Contingent immunization is a strategy that consists of identifying both the available

immunization target rate and a lower safety net level return with which the investor would be
minimally satisfied.
To illustrate this strategy, suppose that a client investing $50 million is willing to accept a 10%
rate of return over a four-year investment horizon at a time when a possible immunized rate of
return is 12%. The 10% return is called the safety net return. The difference between the
immunized return and the safety net return is called the safety cushion. In our example, the
safety cushion is 200 basis points (12% minus 10%).
The three key factors in implementing a contingent immunization strategy are (i) establishing
accurate immunized initial and ongoing available target returns, (ii) identifying a suitable and
immunizable safety net return, and (iii) designing an effective monitoring procedure to ensure
that the safety net return is not violated.
STRUCTURING A PORTFOLIO TO SATISFY MULTIPLE LIABILITIES
For pension funds, there are multiple liabilities that must be satisfied—payments to the
beneficiaries of the pension fund. A stream of liabilities must also be satisfied for a life insurance
company that sells an insurance policy requiring multiple payments to policyholders, such as an
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annuity policy. There are two strategies that can be used to satisfy a liability stream: multiperiod
immunization, and cash flow matching.
Multiperiod Immunization
Multiperiod immunization is a portfolio strategy in which a portfolio is created that will be

capable of satisfying more than one predetermined future liability regardless if interest rates
change. Even if there is a parallel shift in the yield curve, it has been demonstrated that matching
the duration of the portfolio to the duration of the liabilities is not a sufficient condition to
immunize a portfolio seeking to satisfy a liability stream. Instead, it is necessary to decompose
the portfolio payment stream in such a way that each liability is immunized by one of the
component streams. The key to understanding this approach is recognizing that the payment
stream on the portfolio, not the portfolio itself, must be decomposed in this manner. There may
be no actual bonds that would give the component payment stream.
Cash Flow Matching
An alternative to multiperiod immunization is cash flow matching. This approach, also referred
to as dedicating a portfolio, can be summarized as follows. A bond is selected with a maturity
that matches the last liability stream. An amount of principal plus final coupon equal to the
amount of the last liability stream is then invested in this bond. The remaining elements of the
liability stream are then reduced by the coupon payments on this bond, and another bond is
chosen for the new, reduced amount of the next-to-last liability. Going backward in time, this
cash flow matching process is continued until all liabilities have been matched by the payment of
the securities in the portfolio.
A popular variation of multiperiod immunization and cash flow matching to fund liabilities is
one that combines the two strategies. This strategy, referred to as combination matching or
horizon matching, creates a portfolio that is duration matched with the added constraint that it
be cash matched in the first few years, usually five years.
EXTENSIONS OF LIABILITY FUNDING STRATEGIES
Deterministic models assume that the cash flows from assets and liabilities are known with
certainty. However, most non-Treasury securities have embedded options that permit the
borrower or the investor to alter the cash flows.
A number of models have been developed to handle real-world situations in which liability
payments and/or asset cash flows are uncertain. Such models are called stochastic models. Such
models require that the portfolio manager incorporate an interest-rate model, that is, a model that
describes the probability distribution for interest rates.
Optimal portfolios then are solved for using a mathematical programming technique known as
stochastic programming. There is increasing awareness that stochastic models reduce the
likelihood that the liability objective will not be satisfied and that transactions costs can be
reduced through less frequent rebalancing of a portfolio derived from these models.
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COMBINING ACTIVE AND IMMUNIZATION STRATEGIES
In contrast to an immunization strategy, an active/immunization combination strategy is a

mixture of two strategies that are pursued by the money manager at the same point in time. The
immunization component of this strategy could be either a single-liability immunization or a
multiple-liability immunization. This component involves an adaptive strategy based on an initial
set of liabilities and modified over time to changes in future liabilities. The active portion would
continue to be free to maximize expected return, given some acceptable risk level.
The following formula can be used to determine the portion of the initial portfolio to be managed
actively, with the balance immunized:
immunization target rate - minimum return established by client

active component = .
immunization target rate - expected worst case active return
In the formula it is assumed that the immunization target return is greater than either the
minimum return established by the client or the expected worst-case return from the actively
managed portion of the portfolio.
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ANSWERS TO QUESTIONS FOR CHAPTER 24
(Questions are in bold print followed by answers.)
1. What are the two dimensions of a liability?
The two important dimensions of a liability are the amount and timing of the payment. A
liability is a cash outlay that must be made at a specific time to satisfy the contractual terms of
an issued obligation. An institutional investor is concerned with both the amount and timing of
liabilities, because its assets must produce the cash to meet any payments it has promised to
make in a timely way.
2. Why is it not always simple to estimate the liability of an institution?
It is not simple to estimate the liability of an institution because a liability can have uncertainty
as to both the amount and timing of the cash outlay. When we refer to a cash outlay as being
uncertain, we do not mean that it cannot be predicted. There are some liabilities for which “law
of large numbers” makes it easier to predict the timing and/or amount of cash outlays. This work
is typically done by actuaries, but even actuaries have difficulty predicting natural catastrophes
such as floods and earthquakes.
3. Why is asset/liability management best described as surplus management?
Asset/liability management is best described as surplus management because it aims at keeping

and acquiring assets that are greater than liabilities by a specified amount. A measure of how
great assets are to liabilities is called the surplus. The surplus of any entity can be defined as the
difference between the value of all its assets and the value of its liabilities. Asset/liability
management involves maintaining a surplus which is called a safety net. The asset/liability
management task also involves a trade-off between controlling the risk of a decline in the surplus
and taking on acceptable risks in order to earn an adequate return on the funds invested.
4. Answer the following questions.
(a) What is the economic surplus of an institution?
The economic surplus of any entity is the difference between the market value of all its assets
and the market value of its liabilities; that is,
economic surplus = market value of assets – market value of liabilities.
The market value of liabilities is simply the present value of the liabilities in which the liabilities
are discounted at an appropriate interest rate. A rise in interest rates will therefore decrease the
present value or market value of the liabilities; a decrease in interest rates will increase the
present value or market value of liabilities. Thus the economic surplus can be expressed as
economic surplus = market value of assets – present value of liabilities.
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(b) What is the accounting surplus of an institution?
Accounting surplus is surplus of assets over liabilities as reported in financial statements based
on generally accepted accounting principles (GAAP). The accounting treatment for assets is
governed by Statement of Financial Accounting Standards No. 115, more popularly referred to as
FASB 115. However, it does not deal with the accounting treatment for liabilities. The surplus as
measured using GAAP accounting may differ materially from economic surplus.
(c) What is the regulatory surplus of an institution?
Institutional investors that are regulated at the state or federal levels must provide financial
reports to regulators based on regulatory accounting principles (RAP). RAP accounting for a
regulated institution need not use the same rules as set forth by FASB 115. Liabilities may or
may not be reported at their present value, depending on the type of institution and the type of
liability. The surplus as measured using RAP accounting, called regulatory surplus, may, as in
the case of accounting surplus, differ materially from economic surplus.
(d) Which surplus best reflects the economic well-being of an institution?
Economic surplus best reflects the economic well-being of an institution because these values are
market values and thus best reflect investor’s beliefs about the true financial condition of a firm.
Surplus based on GAAP accounting, specifically, FASB 115, and on RAP accounting may not
reflect the true financial condition of an institution. Thus, using these two surplus measures can
hide future financial problems.
(e) Under what circumstances are all three surplus measures the same?
For the three methods to produce the same surplus, the liabilities and assets must all be reported
or given as the same.
5. Suppose that the present value of the liabilities of some financial institution is $600
million and the surplus $800 million. The duration of the liabilities is equal to 5. Suppose
further that the portfolio of this financial institution includes only bonds and the duration
for the portfolio is 6.
Answer the following questions.
(a) What is the market value of the portfolio of bonds?
We rearrange the below equation:
economic surplus = market value of assets – market value of liabilities.
Doing this, we get:
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market value of assets = economic surplus + market value of liabilities.
Inserting our given values, we get:
market value of assets = $800 million + $600 million = $1.4 billion.
(b) What does a duration of 6 mean for the portfolio of assets?
Duration is a measure of the responsiveness of cash flows to changes in interest rates. Duration
can be calculated for liabilities in the same way in which it is calculated for assets. Because the
duration of the assets is 6, the market value of the assets will change by about 6% for a 100 basis
points change in interest rates. Thus, the increase in the market value of the assets is about
0.06($1.4 billion) = $84 million for a 100 basis points decrease in interest rates. Similarly, the
decrease in the market value of the assets is about -0.06($1.4 billion) = -$84 million for a 100
basis points increase in interest rates.
(c) What does a duration of 5 mean for the liabilities?
If the duration of the liabilities is 5, the present value of the liabilities will increase by 5% or
0.05($600 million) = $30 million for a 100 basis point decrease in interest rates. Similarly, it will
decrease by -$30 million for every 100 basis point increase in interest rates.
(d) Suppose that interest rates increase by 50 basis points; what will be the approximate
new value for the surplus?
-0.06 ( $1.4 billion )

The decrease in assets will be = -$42 million. The decrease in liabilities
2
-0.05 ( $600 million )
will be = -$15 million. Thus, the net change in surplus value is:
2
decrease in assets - decrease in liabilities = (-$42 million) - (-$15 million) = -$27 million.
Thus, the surplus will experience a negative change where the new value for surplus is:
old surplus value + change in surplus value = $800 million + (-$27 million) = $773 million.
(e) Suppose that interest rates decrease by 50 basis points; what will be the approximate
new value for the surplus?
0.06 ( $1.4 billion )

The increase in assets will be = $42 million. The increase in liabilities will be
2
0.05 ( $600 million )
= $15 million. Thus, the net change in surplus value is:
2
increase in assets - increase in liabilities = $42 million - $15 million = $27 million.
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Given the net change in surplus value of $27 million, the surplus will experience a positive
change where the new value for surplus is:
old surplus value + change in surplus value = $800 million + $27 million = $827 million.
(a) Why is the interest-rate sensitivity of an institution’s assets and liabilities important?
Knowing the interest-rate sensitivity reveals steps that a firm’s manager can perform to avoid
financial difficulties caused by being short of assets relative to liabilities.
To see why the interest-rate sensitivity of an institution’s assets and liabilities is important,
consider an institution that has a portfolio consisting only of bonds and liabilities. If interest rates
rise, both the bonds and liabilities will decline in value. However, the economic surplus can
increase, decrease, or not change. The net effect on economic surplus depends on the relative
interest rate sensitivity of the assets compared to the liabilities. Because duration is a measure of
the responsiveness of cash flows to changes in interest rates, duration can be calculated for
liabilities in the same way in which it is calculated for assets. Thus the duration of liabilities
measures their responsiveness to a change in interest rates. If the duration of the assets is greater
than the duration of the liabilities, the economic surplus will increase if interest rates fall.
(b) In 1986, Martin Leibowitz of Salomon Brothers Inc., wrote a paper titled “Total
Portfolio Duration: A New Perspective on Asset Allocation.” What do you think a total
portfolio duration means?
One would think that total portfolio duration refers to the duration of all assets together. If bonds
in the portfolio are all assumed to be option-free bonds, total portfolio duration means modified
duration can be used to measure duration. However, when portfolios include securities with
embedded options, the effective duration is used. For most institutional portfolios, total portfolio
duration will likely mean an effective duration.
7. If an institution has liabilities that are interest-rate sensitive and invests in a portfolio of
common stocks, can you determine what will happen to the institution’s economic surplus
if interest rates change?
The stock market is generally influenced like bonds and other fixed-income securities when
interest rates change. That is, stock values fall when interest rates increase, and values rise when
rates fall. However, there is much more volatility for common stocks than for fixed-income
securities. Although it would involve some difficulty to predict any precise relationship between
common stock and the institution’s economic surplus if interest rates change, generally one can
say that assets would be more volatile relative to liabilities. If interest rates went down then
assets would go up more than liabilities giving a greater surplus; the opposite would occur if
rates went up.
8. The following quote is taken from Phillip D. Parker (Associate General Counsel of the
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SEC), “Market Value Accounting—An Idea Whose Time Has Come?” in Elliot P. Williams
(ed.), Managing Asset/Liability Portfolios (Charlottesville, VA: Association for Investment
Management and Research, 1991), published prior to the passage of FASB 115: “The use of
market value accounting would eliminate any incentive to sell or retain investment
securities for reasons of accounting treatment rather than business utility.”
Explain why this statement is correct. (Note that in historical accounting a loss is
recognized only when a security is sold.)
Accounting treatment that occurs in annual reports is concerned with making the firm’s book
numbers look good. Thus, it is not primarily concerned with providing numbers that reflect
market values especially when market value numbers are poor. If book numbers can be
manipulated by accounting practices to paint a rosy picture of the company’s earnings and well-
being, then the company’s accountants will do that. Thus, the statement is correct when it
suggests that using market value accounting can eliminate practices concerned with overvaluing
that company’s assets. This statement is especially true to the extent that market values differ
from book values and accounting practices do not properly adjust for market numbers unless the
asset is sold.
(a) Indicate why you agree or disagree with the following statement: “Under FASB 115 all
assets must be marked to market.”
As explained below in more detail, FASB 115 does not require that all assets must be marked to
market even though many have to be marked to market.
Institutional investors must prepare periodic financial statements in accordance with GAAP.
Thus the assets and liabilities reported are based on GAAP accounting. The accounting treatment
for assets is governed by FASB 115. However, it does not deal with the accounting treatment for
liabilities.
With respect to the financial reporting of assets, there are three possible methods for reporting:
amortized cost or historical cost, market value, or the lower of cost or market value. Despite the
fact that the real cash flow is the same regardless of the accounting treatment, there can be
substantial differences in the financial statements using these three methods.
In the amortized cost method, the value reported in the balance sheet reflects an adjustment to
the acquisition cost for debt securities purchased at a discount or premium from their maturity
value. In the market value accounting method, the balance sheet reported value of an asset is
its market value. When an asset is reported in the financial statements of an institution at its
market value, it is said to be “marked to market.” Finally, the lower of cost or market method
requires comparison of market value to the amortized cost, with the lower of these two values
reported in the balance sheet. The value reported cannot exceed the amortized cost.
FASB 115 specifies which of these three methods must be followed for assets. Specifically, the
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accounting treatment required for a security depends on how the security is classified. There are
three classifications of investment accounts: (i) held to maturity, (ii) available for sale, and (iii)
trading.
The held-to-maturity account includes assets that the institution plans to hold until they mature.
The assets classified in this account cannot be common stock because they have no maturity. For
all assets in the held-to-maturity account, the amortized cost method must be used. An asset is
classified as in the available-for-sale account if the institution does not have the ability to hold
the asset to maturity or intends to sell it. An asset that is acquired for the purpose of earning a
short-term trading profit from market movements is classified in the trading account. For all
assets in the available-for-sale and trading accounts, market value accounting is used.
(b) Indicate why you agree or disagree with the following statement: “The greater the price
volatility of assets classified in the held-to-maturity account, the greater the volatility of the
accounting surplus and reported earnings.”
In general one might agree that if there is volatility in assets, there might be volatility in the
account numbers that reflect this volatility. However, under FASB 115, the accounting treatment
for any unrealized gain or loss depends on the account in which the asset is classified.
Specifically, any unrealized gain or loss is ignored for assets in the held-to-maturity account.
Thus, it would seem that this account would not generally have much volatility. Thus, for assets
in this account there is no affect on reported earnings or the accounting surplus and thus no
volatility. For the other two accounts, any unrealized gain or loss affects the accounting surplus.
However, there is a difference as to how reported earnings are affected. For assets classified in
the available-for-sale account, unrealized gains or losses are not included in reported earnings; in
contrast, for assets classified in the trading account, any gains or losses are included in reported
earnings. In conclusion, volatility in accounting surplus and reported earnings will reflect the
manner in which assets are classified.
10. What is meant by immunizing a bond portfolio?
Immunizing a bond portfolio means that the portfolio’s value is protected against a general
change in the rate of interest.
portfolio can fail to achieve the target accumulated value. This can occur when the fall in
principal is greater than any increase in reinvestment rate. In other words, the interest rate (or
price) risk has a greater impact that the reinvestment risk. To avoid this loss (and immunize its
portfolio from interest rate changes), the portfolio manager should look for a coupon bond so that
however the market yield changes, the change in the interest on interest will be offset by the
change in the price.
The equality of the duration of the asset and the duration of the liability is the key to
immunization. When generalizing this observation to portfolios, the key is to immunize a
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portfolio’s target accumulated value (target yield). To do this, a portfolio manager must construct
a bond portfolio such that the duration of the portfolio is equal to the duration of the liability and
the present value of the cash flow from the portfolio equals to the present value of the future
liability.
(a) What is the basic underlying principle in an immunization strategy?
The basic underlying principle in an immunization strategy is to have the duration of the asset
equal the duration of the liability. Generalizing this observation to bond portfolios from
individual bonds, the key principle is: to immunize a portfolio’s target accumulated value (target
yield), a portfolio manager must construct a bond portfolio such that (i) the duration of the
portfolio is equal to the duration of the liability, and (ii) the present value of the cash flow from
the portfolio equals to the present value of the future liability.
(b) Why may the matching of the maturity of a coupon bond to the remaining time to
maturity of a liability fail to immunize a portfolio?
portfolio can fail to achieve the target accumulated value. This can occur when the fall in
principal is greater than any increase in reinvestment rate. In other words the interest rate (or
price) risk has a greater impact that the reinvestment risk. To avoid this loss (and immunize its
portfolio from interest rate changes), the portfolio manager should look for a coupon bond so that
however the market yield changes, the change in the interest on interest will be offset by the
change in the price.
12. Why must an immunized portfolio be rebalanced periodically?
The key to immunizing a portfolio of assets is to match the duration of the assets with the
liabilities. Because market yields can change periodically affecting the duration of the assets, the
portfolio of assets must be rebalanced periodically to insure immunization.
Illustrations of the principles underlying immunization often assume a one-time instantaneous

change in the market yield. In practice, the market yield will fluctuate over the investment
horizon. As a result, the duration of the portfolio will change as the market yield changes. In
addition, the duration will change simply because of the passage of time.
Even in the face of changing market yields, a portfolio can be immunized if it is rebalanced so
that its duration is equal to the duration of the liability’s remaining time. For example, if the
liability is initially 5.5 years, the initial portfolio should have a duration of 5.5 years. After six
months the liability will be five years, but the duration of the portfolio will probably be different
from five years. This is because duration depends on the remaining time to maturity and the new
level of yields, and there is no reason why the change in these two values should reduce the
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duration by exactly six months. Thus the portfolio must be rebalanced so that its duration is five
years. Six months later the portfolio must be rebalanced again so that its duration will equal 4.5
years. And so on.
There is the question of how often the portfolio should be rebalanced to adjust its duration. On
the one hand, the more frequent rebalancing increases transactions costs, thereby reducing the
likelihood of achieving the target yield. On the other hand, less frequent rebalancing will result in
the duration wandering from the target duration, which will also reduce the likelihood of
achieving the target yield. Thus the portfolio manager faces a tradeoff in that some transactions
costs must be accepted to prevent the duration from straying from its target, but some adjustment
in the duration must be accepted or transactions costs will become prohibitively high.
13. What are the risks associated with a bond immunization strategy?
As described below, there are risks that can upset various types of bond immunization strategies.
A first risk involves uncertainty as to how the yield curve might shift. For example, if there is a
change in interest rates that does not correspond to the shape-preserving shift, matching the
portfolio’s duration to the liability’s duration will not assure immunization. The sufficient
condition for the immunization of a single liability is that the duration of the portfolio be equal to
the duration of the liability. However, a portfolio will be immunized against interest-rate changes
only if the yield curve is flat and any changes in the yield curve are parallel changes (i.e., interest
rates move either up or down by the same number of basis points for all maturities). Duration is a
measure of price volatility for parallel shifts in the yield curve. If there is a change in interest
rates that does not correspond to this shape-preserving shift, matching the portfolio’s duration to
the liability’s duration will not assure immunization. That is, the target yield will no longer be the
minimum total return for the portfolio.
A second risk involves the reinvestment rate. For example, consider the example in the text
where the accumulated value for a barbell portfolio at the liability due date misses the target
accumulated value by more than a bullet portfolio. There are two reasons for this. First, the lower
reinvestment rates are experienced on the barbell portfolio for larger interim cash flows over a
longer time period than on the bullet portfolio. Second, the portion of the barbell portfolio still
outstanding at the end of the liability due date is much longer than the maturity of the bullet
portfolio, resulting in a greater capital loss for the barbell than for the bullet. Thus the bullet
portfolio has less risk exposure than the barbell portfolio to any changes in the interest-rate
structure that might occur. What should be evident from this analysis is that immunization risk is
the risk of reinvestment. The portfolio that has the least reinvestment risk will have the least
immunization risk. When there is a high dispersion of cash flows around the liability due date,
the portfolio is exposed to high reinvestment risk. When the cash flows are concentrated around
the liability due date, the portfolio is subject to low reinvestment risk.
14. “I can immunize a portfolio simply by investing in zero-coupon Treasury bonds.”

Comment on this statement.
If all the cash flows are received at the liability due date, the immunization risk measure is zero.
223
In such a case the portfolio is equivalent to a pure discount security (zero-coupon security) that
matures on the liability due date. If a portfolio can be constructed that replicates a pure discount
security maturing on the liability due date, that portfolio will be the one with the lowest
immunization risk. Typically, however, it is not possible to construct such an ideal portfolio.
An alternative approach to immunizing a portfolio against changes in the market yield is to

invest in zero-coupon bonds with a maturity equal to the investment horizon. This is consistent
with the basic principle of immunization because the duration of a zero-coupon bond equals the
liability’s duration. However, in practice, the yield on zero-coupon bonds is typically lower than
the yield on coupon bonds. Thus using zero-coupon bonds to fund a bullet liability requires more
funds because a lower target yield (e.g., yield on the zero-coupon bond) is being locked in.
Suppose, for example, that a portfolio manager must invest funds to satisfy a known liability of
$20 million five years from now. If a target yield of 10% on a bond-equivalent basis (5% every
six months) can be locked in using zero-coupon Treasury bonds, the funds necessary to satisfy
the $20 million liability will be $12,278,260, the present value of $20 million using a discount
rate of 10% (5% semiannually).
Suppose, instead, that by using coupon Treasury securities, a target yield of 10.3% on a bond-
equivalent basis (5.15% every six months) is possible. Then the funds needed to satisfy the $20
million liability will be $12,104,240, the present value of $20 million discounted at 10.3%
(5.15% semiannually). Thus a target yield higher by 30 basis points would reduce the cost of
funding the $20 million by $12,278,260 – $12,104,240 = $174,020. But the reduced cost comes
at a price—the risk that the target yield will not be achieved.
15. Three portfolio managers are discussing a strategy for immunizing a portfolio so as to
achieve a target yield. Manager A, whose portfolio consists of Treasury securities and
option-free corporates, stated that the duration of the portfolio should be constructed so
that the Macaulay duration of the portfolio is equal to the number of years until the
liability must be paid. Manager B, with the same types of securities in his portfolio as
Manager A, feels that Manager A is wrong because the portfolio should be constructed so
that the modified duration of the portfolio is equal to the modified duration of the
liabilities. Manager C believes Manager B is correct. However, unlike the portfolios of
Managers A and B, Manager C invests in mortgage-backed securities and callable
corporate bonds. Discuss the position taken by each manager and explain why they are
correct.
Manager A wants to use the Macaulay duration for his Treasury securities and option-free
corporates. This is an acceptable measure if assets and liabilities are option-free. However,
Manager A wants the duration of assets to equal the number of years until the liability must be
paid. Suppose the duration of the assets is 5 and the duration of the liabilities is not 5, but say 3.
If interest rates increase by 100 basis points then the market value of the assets will increase by
approximately 5%. The liabilities will also increase but only by about 3%. Thus, the economic
surplus will increase. If the rates decrease by 100 basis points, the opposite would occur, i.e., the
surplus would decrease.
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Manager B wants to overcome the problems faced by Manager A by matching the modified
duration of the assets with the modified duration of the liabilities. Due to the relation between the
modified duration and Macaulay duration, the modified duration analysis can be classified in
terms of the latter.
Manager C should agree with Manager B’s choice but should not agree that Manager B’s
strategy applies to its portfolio. This is because Manager C’s portfolio contains securities with
embedded option. When portfolios include securities with embedded options, the effective
duration is used.
16. Why is there greater risk in a multiperiod immunization strategy than a cash flow-
matching strategy?
To understand the greater risk in a multiperiod immunization strategy, we need to first

understand the differences between the cash flow matching and multiperiod immunization
strategies. First, unlike the immunization approach, the cash flow matching approach has no
duration requirements. Second, with immunization, rebalancing is required even if interest rates
do not change. In contrast, no rebalancing is necessary for cash flow matching except to delete
and replace any issue whose quality rating has declined below an acceptable level. Third, there is
no risk that the liabilities will not be satisfied (barring any defaults) with a cash flow-matched
portfolio. For a portfolio constructed using multiperiod immunization, there is immunization risk
due to reinvestment risk.
The differences just cited may seem to favor the use of cash flow matching. However, what we
have ignored is the relative cost of the two strategies. Cash flow matching is more expensive
because, typically, the matching of cash flows to liabilities is not perfect. This means that more
funds than necessary must be set aside to match the liabilities. Optimization techniques used to
design cash flow-matched portfolios assume that excess funds are reinvested at a conservative
reinvestment rate. With multiperiod immunization, all reinvestment returns are assumed to be
locked in at a higher target rate of return.
In conclusion, money managers face a trade-off in deciding between the two strategies:
avoidance of the risk of not satisfying the liability stream under cash flow matching versus the
lower cost attainable with multiperiod immunization.
17. Answer the below questions.
(a) What is a contingent immunization strategy?
A contingent immunization strategy is a strategy that consists of identifying both the available
immunization target rate and a lower safety net level return with which the investor would be
minimally satisfied. More details are given below.
For a contingent immunization strategy, the money manager pursues an active portfolio strategy
until an adverse investment experience drives the then-available potential return—the combined
active return from actual past experience and immunized return from expected future experience
225
—down to the safety net level. When that point is reached, the money manager is obligated to
immunize the portfolio completely and lock in the safety net level return. As long as the safety
net is not violated, the money manager can continue to manage the portfolio actively. When the
immunization mode is activated because the safety net is violated, the manager can no longer
return to the active mode, unless, of course, the contingent immunization plan is abandoned.
(b) What is the safety net cushion in a contingent immunization strategy?
The safety cushion is the difference between the immunized return and the safety net return.
More details including an illustration of the safety cushion is given below.
Suppose that a client investing $50 million is willing to accept a 10% rate of return over a four-
year investment horizon at a time when a possible immunized rate of return is 12%. The 10%
return is called the safety net return. The difference between the immunized return and the safety
net return is called the safety cushion. In our example, the safety cushion is 200 basis points
(12% minus 10%).
Because the initial portfolio value is $50 million, the minimum target value at the end of four
years, based on semiannual compounding, is $50,000,000(1.05)8 = $73,872,772. The rate of
return at the time is 12%, so the assets required at this time to achieve the minimum target value
of $73,872,772 represent the present value of $73,872,772 discounted at 12% on a semiannual
basis, which is $73,872,772/(1.06)8 = $46,350,089. Therefore, the safety cushion of 200 basis
points translates into an initial dollar safety margin of $50,000,000 – $46,350,089 = $3,649,911.
Had the safety net of return been 11% instead of 10%, the safety cushion would have been 100
basis points and the initial dollar safety margin, $1,855,935. In other words, a smaller safety
cushion implies a smaller dollar safety margin.
(c) Is it proper to classify a contingent immunization as a combination active/immunization

strategy?
In a contingent strategy, the money manager is permitted to manage the portfolio actively until
the safety net is violated. The manager could theoretically employ an active strategy for the
whole period. While it is doing this, it is also following the guidelines of an immunization
strategy. Given these considerations, one might classify a contingent immunization as a
combination active/immunization strategy even though there is no guarantee that an active
strategy can be employed for the whole period. However, strictly speaking contingent
immunization is not a combination or mixture strategy. The money manager is either in the
immunization mode by choice or because the safety net is violated or in the active management
mode.
In contrast to an immunization strategy, an active/immunization combination strategy is a

mixture of two strategies that are pursued by the money manager at the same point in time. The
immunization component of this strategy could be either a single-liability immunization or a
multiple-liability immunization. In the single-liability immunization case, an assured return
would be established so as to serve to stabilize the portfolio’s total return. In the multiple liability
immunization case, the component to be immunized would be immunized now, with new
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requirements, as they become known, taken care of through reimmunization. This would be an
adaptive strategy in that the immunization component would be based on an initial set of
liabilities and modified over time to changes in future liabilities (e.g., for actuarial changes for
the liabilities in the case of a pension fund). The active portion would continue to be free to
maximize expected return, given some acceptable risk level.
18. What is a combination matching strategy?
A popular variation of multiperiod immunization and cash flow matching to fund liabilities is
one that combines the two strategies. This strategy, referred to as combination matching or
horizon matching, creates a portfolio that is duration matched with the added constraint that it
be cash matched in the first few years, usually five years. The advantage of combination
matching over multiperiod immunization is that liquidity needs are provided for in the initial
cash flow-matched period. Cash flow matching the initial portion of the liability stream reduces
the risk associated with nonparallel shifts of the yield curve. The disadvantage of combination
matching over multiperiod immunization is that the cost is slightly greater.
19. In a stochastic liability funding strategy, why is an interest-rate model needed?
Changes in interest rates impact the cash flows for a stochastic liability funding strategy. Thus,
an interest model is needed to track the cash flows. More details are given below.
Since the mid-1980s, a number of models have been developed to handle real-world situations in
which liability payments and/or asset cash flows are uncertain. Such models are called stochastic
models. Such models require that the portfolio manager incorporate an interest-rate model, that
is, a model that describes the probability distribution for interest rates. Optimal portfolios then
are solved for using a mathematical programming technique known as stochastic programming.
The complexity of stochastic models, however, has limited their application in practice.
Nevertheless, they are gaining in popularity as more portfolio managers become comfortable
with their sophistication. There is increasing awareness that stochastic models reduce the
likelihood that the liability objective will not be satisfied and that transactions costs can be
reduced through less frequent rebalancing of a portfolio derived from these models.
20. Suppose that a client has granted a money manager permission to pursue an
active/immunized combination strategy. Suppose further that the minimum return
expected by the client is 9% and that the money manager believes that an achievable
immunized target return is 14% and the worst possible return from the actively managed
portion of the portfolio is 1%. Approximately how much should be allocated to the active
component of the portfolio?
The following formula can be used to determine the portion of the initial portfolio to be managed
actively, with the balance immunized:
immunization target rate - minimum return established by client

active component = .
immunization target rate - expected worst case active return
227
In the formula it is assumed that the immunization target return is greater than either the
minimum return established by the client or the expected worst-case return from the actively
managed portion of the portfolio. Inserting in our values we get:
14% - 9% 5%
active component = = = 0.384615 or about 38.46%.
14% - 1% 13%
21. One of your clients, a newcomer to the life insurance business, questioned you about the
following excerpt from Peter E. Christensen, Frank J. Fabozzi, and Anthony LoFaso,
“Dedicated Bond Portfolios,” Chapter 43 in Frank J. Fabozzi (ed.), The Handbook of Fixed
Income Securities (Homewood, IL: Richard D. Irwin, 1991):
For financial intermediaries such as banks and insurance companies, there is a well-
recognized need for a complete funding perspective. This need is best illustrated by
the significant interest-rate risk assumed by many insurance carriers in the early
years of their Guaranteed Investment Contract (GIC) products. A large volume of
compound interest (zero-coupon) and simple interest (annual pay) GICs were issued
in three- through seven-year maturities in the positively sloped yield-curve
environment of the mid-1970s. Proceeds from hundreds of the GIC issues were
reinvested at higher rates in the longer 10- to 30-year private placement, commercial
mortgage, and public bond instruments. At the time, industry expectations were that
the GIC product would be very profitable because of the large positive spread
between the higher “earned” rate on the longer assets and the lower “credited” rate
on the GIC contracts.
By pricing GICs on a spread basis and investing the proceeds on a mismatched basis,
companies gave little consideration to the rollover risk they were assuming in
volatile markets. As rates rose dramatically in the late 1970s and early 1980s, carriers
were exposed to disintermediation as GIC liabilities matured and the corresponding
assets had 20 years remaining to maturity and were valued at only a fraction of their
original cost.
Answer the below questions posed to you by your client.
(a) “It is not clear to me what risk an issuer of a GIC is facing. A carrier can invest the
proceeds in assets offering a higher yield than they are guaranteeing to GIC policyholders,
so what’s the problem? Isn’t it just default risk that can be controlled by setting tight credit
standards?”
An issuer of a GIC is facing reinvestment rate risk. As rates increase, the issuer of a GIC will
face paying a higher rate of return on subsequent securities because GICs mature in three to
seven years. This liability is matched by a longer term asset that pays an increasingly lower
return compared to what GICs yield as interest rates rise. Because the funds are tied up in longer
term assets, it is not true that money will be available so that a carrier can invest the proceeds in
assets offering a higher yield than they are guaranteeing to GIC policyholders. The problem is
228
that assets and liabilities were not matched in terms of duration. As interest rates increased the
assets gave a return too low to meet the return guaranteed on the liabilities. This problem has no
immediate relationship to default risk. However, due to the mismatch in assets and liabilities the
company has put itself in a precarious net surplus situation.
(b) “I understand that disintermediation means that when a policy matures, the funds are
withdrawn from the insurance company by the policyholder. But why would a rise in
interest rates cause GIC policyholders to withdraw their funds? The insurance company
can simply guarantee a higher interest rate.”
Under a GIC policy, for a lump-sum payment a life insurance company guarantees that specified
dollars will be paid to the policyholder at a specified future date. Or, equivalently, the financial
institution (i.e., life insurance company) guarantees a specified rate of return on the payment.
However, it cannot simply guarantee the same (or a higher) rate for ensuing periods even if rates
increase because its assets used to match the GIC liability may not be earning (or able to earn)
that rate. Regardless of the insurance company’s dilemma, there can be a number of reasons why
policyholders will withdraw funds. First, the policy matures and client wants to spend the money.
Second, the policyholders need for insurance may change. Third, policyholders may feel they
can make a rate of return on an investment elsewhere which better suits their needs.
(c) “What do the authors mean by ‘pricing GICs on a spread basis and investing the
proceeds on a mismatched basis,’ and what is this ‘rollover risk’ they are referring to?”
The GICs were priced such that the bank and insurance companies would realize what they
believed was a healthy spread compared to other possible liabilities. However, the profit was
placed in assets of a different maturity. As interest rates rose, they were faced by investors who
wanted rates of return similar to the prevailing rates. However, they had already placed much of
their funds in assets with longer maturity or mismatched maturity. The rollover risk stems from
the fact that investors want to reinvest in the GICs issued by the institutions but the institutions’
assets cannot pay the prevailing rate.
22. Suppose that a life insurance company sells a five-year guaranteed investment contract
that guarantees an interest rate of 7.5% per year on a bond-equivalent yield basis (or
equivalently, 3.75% every six months for the next 10 six-month periods). Also suppose that
the payment made by the policyholder is $9,642,899.
Consider the following three investments that can be made by the portfolio manager:
Bond X: Buy $9,642,899 par value of an option-free bond selling at par with a 7.5% yield to
maturity that matures in five years.
Bond Y: Buy $9,642,899 par value of an option-free bond selling at par with a 7.5% yield to
maturity that matures in 12 years.
Bond Z: Buy $10,000,000 par value of a six-year 6.75% coupon option-free bond selling at
96.42899 to yield 7.5%.
229
Answer the below questions.
(a) Holding aside the spread that the insurance company seeks to make on the invested
funds, demonstrate that the target accumulated value to meet the GIC obligation five years
from now is $13,934,413.
To compute the target accumulated value, we need to take the future value of the annuity
resulting from the policyholder’s payment and add it to this payment due at the end of the last
period. We have:
�annual coupon rate � � (1 + y ) n - 1 �
target accumulated value = � �(P) � �+ P
� 2 � � y �
where the semiannual coupon rate = annual payment  2 = 7.5%  2 = 3.75%; the payment or
price of bond (P) = $9,642,899; the yield = y = 7.5%  2 = 3.75%; and, the total number of
periods (n) = 5(2) = 10. Inserting these values into our target accumulated formula, we get:
�0.075 � �
(1.0375)10 - 1 �
target accumulated value = � �($9,642,899) � �+ $9,642,899 =
� 2 � � 0.0375 �
$361,608.71[11.86783847] + $9,642,899 = $4,291,513.79 + $9,642,899 = $13,934,412.79.
Thus, the target accumulated value is about $13,934,413.
(b) Complete Table A assuming that the manager invests in bond X and immediately
following the purchase, yields change and stay the same for the five-year investment
horizon.
For the each row, we have six columns. Below we show how all values are gotten for the first
row of 11.00%. The same process can be repeated to get values for the remaining rows.
Column One gives the new yield which is 11% for the first row. This means the semiannual yield
will be 5.5%. This value changes for each row with each new yield provided for each row.
Column Two provides the coupon which is the total interest paid for each of the ten periods.
Thus, the interest paid is ten times the semiannual coupon payment. The semiannual coupon
payment is the annual coupon rate divided by two (i.e., 0.075  2 = 0.0375) times the par value
purchased of $9,642,899. We have: 10[(0.0375)($9,642,899]) = 10[$361,608.71] =
$3,616,087.13 or about $3,616,087. This value is the same for each row since the coupon rate of
7.5% does not change.
Column Three provides interest on interest. To get interest on interest, we compute (i) the future
value of semiannual coupon payment annuity for ten periods at the yield of 11%  2 = 5.5%, and
(ii) the total interest paid which is the number of periods (10) times the semiannual coupon
230
payment (0.0375 × $9,642,899). For (iii), we take the value in (i) minus the value in (ii).
�annual coupon rate � � (1 + y ) n - 1 � �

(1.055) - 1 �
10
�0.075 �
For (i), we have: � (P)
� � �= � �($9,642,899) � �
� 2 � � y � � 2 � � 0.055 �
= $361,608.71[12.87535379] = $4,655,840.11.
For (ii), we have: n(semiannual coupon payment) = 10[(0.0375)($9,642,899]) = 10[$361,608.71]

= $3,616,087.13. Note that this value is the value also computed in column two.
For (iii), we have: $4,655,840.11 – $361,608.71 = $1,039,752.98 or about $1,039,753.
This third column value changes for each row because it is a function of the new yield which
changes for each row. For example, for the second row we repeat the above process using 10% 
2 = 5.0% to compute the future value of semiannual coupon payment annuity.
Column Four provides the maturity value of the bond, which is $9,642,899. This value is the
same for each row since the investment horizon is the same as the maturity. When the maturity
value increases then the value will not equal $9,642,899.
Column Five is the total accumulated value. This is computed by adding (i) the future value of
semiannual coupon payment annuity for ten periods at the yield of 11%  2 = 5.5% and (ii) the
maturity value given in the fourth column. The value for (i) was given previously as
$4,655,840.11 when computing the interest on interest. This value is also given by adding the
second and third column values. The value for (ii) is $9,642,899 as given in the fourth column.
For the accumulated value, we have:
total accumulated value = $4,655,840.11 + $9,642,899 = $14,298,739.11.
This value changes for each row as it is a function of the new yield which changes for each row.
Column Six, the last column, reports the total return which is given as:
�
� accumulated value �
1/ n
�
total return = 2 �
� � - 1�
�policyholder payment �
�
� �
�
where accumulated value is the fifth column value of $14,298,739.11, the policyholder payment
is the value of $9,642,899, and n is the number of periods which is 10. Inserting in these values,
we have:
 $14,298,739.11 1 / 10 
2  $9,642,899  - 1 = 2[(1.482825767)0.1 – 1] = 2[1.040181 – 1] = 0.0803625 or

  

about 8.04%. This value changes for each row because it is a function of the new yield which
changes for each row.
231
We repeat the above process to get all values for each row. These values are given below with
Table A filled in.
Table A
Accumulated Value and Total Return After Five Years:
Five-Year 7.5% Bond Selling to Yield 7.5%
Investment horizon (years): 5
Coupon rate: 7.50%
Maturity (years): 5
Yield to maturity: 7.50%
Price: 100.00000
Par value purchased: $9,642,899
Purchase price: $9,642,899
Target accumulated value: $13,934,413
After Five Years
Interest on Price of Accumulated
New Yield Coupon Interest Bond Value Total Return
11.00% $3,616,087 $1,039,753 $9,642,899 $14,298,739 8.04%
10.00% $3,616,087 $ 932,188 $9,642,899 $14,191,175 7.88%
9.00% $3,616,087 $ 827,436 $9,642,899 $14,086,423 7.73%
8.00% $3,616,087 $ 725,426 $9,642,899 $13,984,412 7.57%
7.50% $3,616,087 $ 675,427 $9,642,899 $13,934,413 7.50%
7.00% $3,616,087 $ 626,089 $9,642,899 $13,885,073 7.43%
6.00% $3,616,087 $ 529,352 $9,642,899 $13,788,338 7.28%
5.00% $3,616,087 $ 435,153 $9,642,899 $13,694,139 7.14%
4.00% $3,616,087 $ 343,427 $9,642,899 $13,602,414 7.00%
(c) Based on Table A, under what circumstances will the investment in bond X fail to satisfy
the target accumulated value?
Given that the target accumulated value is $13,934,413, we see any new yield below 7.50% will
give an accumulated value which is less than the target. This is due to reinvestment rate risk
which works to the disadvantage of the life insurance company since the coupon must be
invested at a rate below 7.5% which is the guaranteed rate of return.
(d) Complete Table B, assuming that the manager invests in bond Y and immediately
horizon.
row of 11.00%. The same process can be repeated to get values for the remaining rows in the
table.
232
payment is the semiannual coupon rate (0.075  2 = 0.0375) times the par value purchased of
$9,642,899. We have: 10[(0.0375)($9,642,899]) = 10[$361,609.71] = $3,616,087.13 or about
$3,616,087. This value is the same for each row since the coupon rate of 7.5% does not change.
The values for this column for Table B are the same values found in Table A.
value of semiannual coupon payment annuity for ten periods at the yield of 11%  2 = 5.5%, and
�annual coupon rate � � (1 + y ) n - 1 � �0.075 �

For (i), we have: � �(P) � �= � �($9,642,899)
� 2 � � y � � 2 �
 (1.055 )10 - 1
  = $361,608.71[12.87535379] = $4,655,840.11.
 0.055 
For (ii), we have: n(semiannual coupon payment) = 10[(0.0375)($9,642,899]) = 10[$361,608.71]

= $3,616,087.13. Note that this value is the value also computed in column two.
For (iii), we have: $4,655,840.11 – $361,608.71 = $1,039,752.98.
2 = 5% to compute the future value of semiannual coupon payment annuity. The values for this
column for Table B are the same values found in Table A.
Column Four provides the maturity value of the bond, which is $8,024,638.89. This value is
computed by taking the present value of the bond value at the end of five years. Because the
maturity has seven remaining years after five years, this means we compute (i) the value at the
end of five years for an annuity composed of 7(2) = 14 semiannual coupon payments of
$361,608.71 discounted at a yield of 5.5% and (ii) the value at the end of five years for the bond
value of $9,642,899 received in 14 periods and discounted at a yield of 5.5%.
� � 1 ��
�annual coupon rate � � 1- � � �0.075 �
(1+ y) �
n
For (i), we get: � �(P) � � � �= � �($9,642,899)
� 2 � � 2 �
�
� y �
�
� � 1 ��
�1- � 14 ��
( ) = $361,608.71[9.5896479] = $3,467,700.23.
� �1 .055 ��
� 0.055 �
233
P $9, 642,899
For (ii), we get: = = $9,642,899(0.4725693866) = $4,556,938.66.
( 1+ y )
n
( 1.055 ) 14
Adding (i) and (ii), we get the value of the bond price at the beginning of period 11 (or at the end
of period 10) as $3,467,700.23 + $4,556,938.66 = $8,024,638.89 or about $8,024,639. This value
changes for each row because it is a function of the new yield which changes for each row.
second and third column values. The value for (ii) is $8,024,638.89 as given in the fourth
column. For the accumulated value, we have:
total accumulated value = $4,655,840.11 + $8,024,638.89 = $12,680,479.00.
Column Six, the last column, reports the total return which is given by
�
1/ n
�
� � - 1�
�
�
�policyholder payment � �
�
we have:
 $12,680,479 1 / 10 
2  $9,642,899  - 1 = 2[(1.315006929)0.1 – 1] = 2[1.0277626 – 1] = 0.0555252 or
  
We repeat the above process for each row to get all values. These values are given below with
Table B filled in.
Table B
Twelve-Year 7.5% Bond Selling to Yield 7.5%
Coupon rate: 7.50%
Maturity (years): 12
Price: 100.00000
234
After Five Years
11.00% $3,616,087 $1,039,753 $8,024,639 $12,680,479 5.55%
10.00% $3,616,087 $ 932,188 $8,449,753 $12,998,030 6.06%
9.00% $3,616,087 $ 827,436 $8,903,566 $13,347,090 6.61%
8.00% $3,616,087 $ 725,426 $9,388,251 $13,729,764 7.19%
7.50% $3,616,087 $ 675,427 $9,642,899 $13,934,413 7.50%
7.00% $3,616,087 $ 626,089 $9,906,163 $14,148,337 7.82%
6.00% $3,616,087 $ 529,352 $10,459,851 $14,605,289 8.48%
5.00% $3,616,087 $ 435,153 $11,052,078 $15,103,318 9.18%
4.00% $3,616,087 $ 343,427 $11,685,837 $15,645,352 9.92%
(e) Based on Table B, under what circumstances will the investment in bond Y fail to satisfy
Given that the target accumulated value is $13,934,413, we see any new yield above 7.50% will
give accumulated value which is less than the target.
This is due to fact that the increase in interest rates lowers the value of the coupon and principal
payments which are discounted at a higher yield in the future.
This works to the disadvantage of the life insurance company since they have chosen to match
their liability with a longer term twelve-year bond instead of a five-year bond.
One should note that when the market yield increases interest on interest will be greater;
however, the market price of the bond decreases.
The net effect is that the accumulated value is less than the target accumulated value. The reverse
is true when the market yield decreases.
The change in the price of the bond will more than offset the decline in the interest on interest,
resulting in an accumulated value that exceeds the target accumulated value.
(f) Complete Table C, assuming that the manager invests in bond Z and immediately
horizon.
row of 11.00%. The same process can be repeated to get values for the remaining rows in the
table.
235
payment is the semiannual coupon rate (0.0675  2 = 0.03375) times the par value purchased of
$10,000,000. We have: 10[(0.03375)($10,000,000]) = 10[$337,500] = $3,375,000. This value is
the same for each row since the coupon rate of 6.75% does not change.
value of semiannual coupon payment annuity for ten periods at the yield of 11%  2 = 5.5% and
�annual coupon rate �  (1 + y ) - 1 �0.0675 �

n
For (i), we have: � �(P)  = � �($10,000,000)

� 2 �  y  � 2 �
 (1.055 )10 - 1
  = $337,500[12.87535379] = $4,345,431.90.
 0.055 
For (ii), we have: n(semiannual coupon payment) = 10[(0.03375)($ 10,000,000]) = 10[$337,500]

= $3,375,000. Note that this value is the value also computed in column two.
For (iii), we have: $4,345,431.90 – $3,375,000 = $970,431.90.
2 = 5% to compute the future value of semiannual coupon payment annuity.
Column Four provides the maturity value of the bond, which is $9,607,657.06. This value is
computed by taking the present value of the bond value at the end of five years. Because the
maturity has one remaining year after five years, this means we compute (i) the value at the end
of five years for an annuity composed of two semiannual coupon payments of $337,500
discounted at a yield of 5.5% and (ii) the value at the end of five years of the bond value of
$10,000,000 received in two periods and discounted at a yield of 5.5%.
� � 1 ��
�annual coupon rate � � 1- � � �0.0675 �
(1+ y) �
n
For (i), we get: � �(P) � � ��= � �($10,000,000)
� 2 � � 2 �
�
� y �
�
� � 1 ��
�1- � 2 ��
� � ( 1 .055 ) ��= $337,500[1.8463197] = $623,132.90.
� 0.055 �
P $10,000,000
For (ii), we get: = = $10,000,000(0.898452416) = $8,984,524.16.
( 1+ y )
n 2
(1.055)
236
Adding (i) and (ii), we get the value of the bond price at the beginning of period 11 (or at the end
of period 10) as $623,132.90 + $8,984,524.16 = $9,607,657.06 or about $9,607,657. This value
changes for each row because it is a function of the new yield which changes for each row.
second and third column values. The value for (ii) is $9,607,657.06 as given in the fourth
column. For the accumulated value, we have:
total accumulated value = $4,345,431.90 + $9,607,657.06 = $13,953,088.96.
Column Six, the last column, reports the total return which is given by
�
1/ n
�
� � - 1�
�
�
�policyholder payment � �
�
we have:
� 1/10
�$13,953,089 � �
2�
�$9,642,899 � - 1�= 2[(1.446980723)0.1 – 1] = 2[1.037638971 – 1] = 0.075278 or
�
� � �
We repeat the above process for each row to get all values. These values are given below with
Table C filled in.
Table C
Six-Year 6.75% Bond Selling to Yield 7.5%
Coupon rate: 6.75%
Maturity (years): 6
Price: 96.42899
237
After Five Years
11.00% $3,375,000 $970,432 $ 9,607,657 $13,953,089 7.53%
10.00% $3,375,000 $870,039 $ 9,789,325 $13,942,885 7.51%
9.00% $3,375,000 $772,271 $ 9,882,119 $13,936,596 7.50%
8.00% $3,375,000 $677,061 $ 9,929,017 $13,934,180 7.50%
7.50% $3,375,000 $630,395 $ 9,976,254 $13,934,413 7.50%
7.00% $3,375,000 $584,345 $10,071,755 $13,935,599 7.50%
6.00% $3,375,000 $494,059 $10,168,650 $13,940,814 7.51%
5.00% $3,375,000 $406,141 $10,266,965 $13,949,791 7.52%
4.00% $3,375,000 $320,531 $10,266,965 $13,962,495 7.54%
(g) Based on Table C, under what circumstances will the investment in bond Z fail to satisfy
There is only one yield in the table that gives a value below the target of $13,934,413 and that is
for 8.00% yield where the target value is $13,934,180 which is $133 off.
(h) What is the modified duration of the liability?
Modified duration is a measure of the sensitivity of a bond’s price to interest-rate changes,

assuming that the expected cash flow does not change with interest rates. One modified duration
expression we can use is:
C � 1 � n ( 100 - [ C / y ] )
1
� - n �
+
� ( 1+ y ) � (1+ y)
n +1
modified duration = y 2
P
where C is the semiannual coupon payment, y is the semiannual yield, n is the number of
semiannual periods, and P is the bond quote in 100’s.
For our bond (expressing numbers in terms of a $100 bond quote), we have: C = $3.75, y =
0.0375, n = 10, and P = $96.43. Inserting these values in our modified duration formula, we can
solve as follows:
C � 1 � n ( 100 - [ C / y ] ) $3.75 � 1 � 10 ( $100 - [ $3.75 / 0.0375] )

1-
� �+ 1-
� 10 �
+
� ( 1+ y ) (1+ y)
n +1
y2 n
� = ( 0.0375 ) 2 � ( 1 .0375 ) � ( 1 .0375) 11
P $96.43
=
$2,666.67 (0.3079795) + $0 $821.28

= = 8.52.
$96.43 $96.43
238
Converting to annual number by dividing by two gives a modified duration for the liabilities of
4.26. The Macaulay duration is 4.13 while the modified duration using the Macaulay relationship
is 3.98.
(i) Complete the following table for the three bonds assuming that each bond is trading to
yield 7.5%:
Bond Modified Duration

5-year, 7.5% coupon, selling at par
12-year, 7.5% coupon, selling at par
6-year, 6.75% coupon, selling for 96,42899
Using the above formula for modified duration, we get the below values as given in the
completed table:
Bond Modified Duration

5-year, 7.5% coupon, selling at par 4.11
12-year, 7.5% coupon, selling at par 7.82
6-year, 6.75% coupon, selling for 96,42899 4.33
(j) For which bond is the modified duration equal to the duration of the liability?
The 6-year, 6.7%% coupon, selling for $96.43 per $100 at the end of 5 years gives the closest
duration to the liability. Rounding off to the nearest tenth, both are equal at 4.3.
(k) Why in this example can one focus on modified duration rather than effective duration?
Modified duration is a measure of the sensitivity of a bond’s price to interest-rate changes,

assuming that the expected cash flows do not change with changes in interest rates. Modified
duration is not an appropriate measure for securities where the projected cash flows change as
interest rates change. The effective duration computation allows for changing cash flow when
interest rates change.
239

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CHAPTER 24

LIABILITY FUND STRATEGIES

GENERAL PRINCIPLES OF ASSET/LIABILITY MANAGEMENT

the economic surplus can be expressed as

economic surplus = market value of assets – present value of liabilities.

IMMUNIZATION OF A PORTFOLIO TO SATISFY A SINGLE LIABILITY

Rebalancing an Immunized Portfolio

CF1 ( 1 - H ) CF2 ( 2 - H ) CFn ( n - H )

Zero-Coupon Bonds and Immunization

An alternative approach to immunizing a portfolio against changes in the market yield is to

Credit Risk and the Target Yield

Constructing the Immunized Portfolio

Contingent immunization is a strategy that consists of identifying both the available

STRUCTURING A PORTFOLIO TO SATISFY MULTIPLE LIABILITIES

Multiperiod immunization is a portfolio strategy in which a portfolio is created that will be

Cash Flow Matching

EXTENSIONS OF LIABILITY FUNDING STRATEGIES

In contrast to an immunization strategy, an active/immunization combination strategy is a

immunization target rate - minimum return established by client

1. What are the two dimensions of a liability?

2. Why is it not always simple to estimate the liability of an institution?

3. Why is asset/liability management best described as surplus management?

Asset/liability management is best described as surplus management because it aims at keeping

4. Answer the following questions.

(a) What is the economic surplus of an institution?

economic surplus = market value of assets – market value of liabilities.

economic surplus = market value of assets – present value of liabilities.

(c) What is the regulatory surplus of an institution?

(d) Which surplus best reflects the economic well-being of an institution?

Answer the following questions.

(a) What is the market value of the portfolio of bonds?

We rearrange the below equation:

economic surplus = market value of assets – market value of liabilities.

Doing this, we get:

Inserting our given values, we get:

market value of assets = $800 million + $600 million = $1.4 billion.

(b) What does a duration of 6 mean for the portfolio of assets?

(c) What does a duration of 5 mean for the liabilities?

-0.06 ( $1.4 billion )

0.06 ( $1.4 billion )

6. Answer the following questions.

9. Answer the following questions.

10. What is meant by immunizing a bond portfolio?

11. Answer the following questions.

(a) What is the basic underlying principle in an immunization strategy?

12. Why must an immunized portfolio be rebalanced periodically?

Illustrations of the principles underlying immunization often assume a one-time instantaneous

14. “I can immunize a portfolio simply by investing in zero-coupon Treasury bonds.”

An alternative approach to immunizing a portfolio against changes in the market yield is to

To understand the greater risk in a multiperiod immunization strategy, we need to first

17. Answer the below questions.

(a) What is a contingent immunization strategy?

(b) What is the safety net cushion in a contingent immunization strategy?

(c) Is it proper to classify a contingent immunization as a combination active/immunization

In contrast to an immunization strategy, an active/immunization combination strategy is a

18. What is a combination matching strategy?

19. In a stochastic liability funding strategy, why is an interest-rate model needed?

immunization target rate - minimum return established by client

Answer the below questions posed to you by your client.

$361,608.71[11.86783847] + $9,642,899 = $4,291,513.79 + $9,642,899 = $13,934,412.79.

Thus, the target accumulated value is about $13,934,413.

�annual coupon rate � � (1 + y ) n - 1 � �