Contingent Immunization

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RoccoLee

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Are the below statements correct?
1. contingent immunization requires the prevailing immunized rate of return to exceed the required rate of return.
2. When interest rate fall, contingent immunization switches to more active management because the dollar safety margin is higher.
 
1. Yes, contringent immunization is an active strategy contingent on making excess returns past a certain threshold (required rate of return).
2. Not always, it depends on the duration of assets and liabilities.
 
Both correct
A) this definitional. Immunication rate > return rate = active management
B) I think this is already assuming you have a safety margin (Assets - Liability). So naturally when rates go down, your assets value will go up. So yes, this is right too.
 
VWJETTY wrote:Both correct
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Not necessarily.
VWJETTY wrote:B) I think this is already assuming you have a safety margin (Assets - Liability). So naturally when rates go down, your assets value will go up.
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And the liability value will increase as well. If the liability value goes up enough, your cushion may vanish.
 
S2000magician wrote:
VWJETTY wrote:Both correct
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Not necessarily.
VWJETTY wrote:B) I think this is already assuming you have a safety margin (Assets - Liability). So naturally when rates go down, your assets value will go up.
Click to expand...
And the liability value will increase as well. If the liability value goes up enough, your cushion may vanish.
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It a question from CFAI material. The answer is both are correct.
But I am doubt with the second statement. Let me post the whole paragrah for discussion later.
 
2. If asset duration > Liability duration; shortening interest rate would persuade portfolio manager to active management
 
guys no doubt about the risk of A/L mismatch in duration BUT the curriculum clearly refers to a fall in interest rates that allow you to a more active management it’s written Black on white, that’s forcely brought me to assume as VWJETTY says.
 
sunseeker wrote:
guys no doubt about the risk of A/L mismatch in duration BUT the curriculum clearly refers to a fall in interest rates that allow you to a more active management it’s written Black on white, that’s forcely brought me to assume as VWJETTY says.
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The change in the cushion depends on the duration mismatch between assets and liabilities.
Active management by having shorter duration assets can still net you excess returns. If it strictly the general level of interest rates, then it’s a duration problem.
UNLESS, the only exception I can think of, is that there was an independent cash contribution (or excess net inflows) moving up the scale of assets PV. In this case, even when durations are matched, you will have a higher dollar safety margin. But the question needs to make it clear, otherwise, the answer is incorrect.
 
Well….
I can see what you guys are talking about now. Yeah, it’s probably a badly worded question because it could technically go both ways. Because they could be talking about just the surplus as well if you think about it. It doesn’t specify between that or whether it’s the entire portfolio and it doesn’t give out the duration.
 
Rocco,
Yes, please post the full paragraph text when you can. I’m interested in the answer to this.
Without any additional information, I would think that 1. was correct and 2. was incorrect because it implicitly assumes asset duration is always greater than liability duration.
Thanks.
 
Curmudgeon wrote:
Rocco,
Yes, please post the full paragraph text when you can. I’m interested in the answer to this.
Without any additional information, I would think that 1. was correct and 2. was incorrect because it implicitly assumes asset duration is always greater than liability duration.
Thanks.
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2016 CFAI Practice problems Reading 21
Question 23
 
Curmudgeon in the contingent immunization paragraph, there’s one example only (the one with TV USD 546.72). If you read through it says
“…if the YTM suddenly drops to 3.75% the initial the dollar safety margin has grown and the manager may therefore commit to a larger proportion of her assets to activie management.…”
Given the example does not contemplate at all any ALM I therefore assume that how the contingent immunization is explained it assumes DUR A > DUR L and I am now wondering whether given a guaranteed RoR we still have to apply DUR A / DUR L.
In the previous years’ discussion it was essentially said that int. rates only change your assets ptf (see below)
http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91309232
In the following book is further confirmed the above concept (no reference to A-L)
https://books.google.it/books?id=B6...gent immunization interest rates fall&f=false
I personally and finally tend to think that if int. rates fall = more safety margin.
 
Sunseeker,
You are correct. I went back and revisited the specific CFA text and it appears to be referring to portfolio assets “in a vacuum,” without regard for the liabilities whatsoever.
This is a good example of where what we know to be true in the real world may not be “true” within the four corners of the CFA text. For our purposes, the impact of interest rate changes on contingent immunization strategies refers to the asset side of the equation only.
Agreed?
 
A poster from the thread you linked also made the good point that immunization is employed when the present value of liabilities is a fixed amount, such that changes in interest rates only impact the asset side of the equation.
For example, I owe my grandmother $500 in one year and purchase a bond to immunize against this liability. Any change in interest rates will impact my asset value (reinvestment risk), but not the fixed value of my liability.
 
Exactly that’s why I was wondering between me and me whether we should really look at the A and L cause in the end we are recalculating the asset base TO BE of a guaranteed Investment contract (GIC). I’d also have difficulties in recognizing the (contingent) liability in the Financial statements along the timelines…this exercise is a focus on the asset base and how this changes with interest rate changes.
 
Curmudgeon wrote:Any change in interest rates will impact my asset value (reinvestment risk), but not the fixed value of my liability.
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Changing interest rates don’t affect the future value of the liability, but they do affect the present value of the liability.
 
but if the duration of asset and liability are given, we need to judge based on the duration difference between asset and liabiility. right?
 
RoccoLee, that’s the point : in the Contingent Immunization exercise Asset and Liabilities duration are never given, the spirit of the exercise is how you value your asset base upon a change in int. rates, again that’s how exercises are usually structured.
 
RoccoLee wrote:
but if the duration of asset and liability are given, we need to judge based on the duration difference between asset and liabiility. right?
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No, you need to judge on the difference in PV as well.
I initially assumed that PVs are equalized, but if this isn’t the case, then even if the duration of assets are lower than the duration of liabilities, you can still have a higher dollar safety margin with lower interest rates.
 
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