FI EOC Question page 152 #27

[cipherap15]

You dont have to read it and goto the page. Summarized it here.
Managing a funding liablity which is currently fully funded utilizing standard immunization approach for a NON CALLABLE bond. Manager is concerned with regards to Interest rate risk, contingent claim risk and cap risk.
It’s multiple choice and I would have chose only IRR and not the other two. I would understand if the security had a contingent claim provision but it’s non callable. In a falling interest rate environment he could have his coupon payments stopped by a large principal payback.
And then with Cap risk that would be associated with Floating rates involved and that’s not the case either here.
Answer has all three as risk factors for the non callable but I would only think IRR.

 

[ArBe]

Don’t have the book here… But isn’t the issue here that the liability in non-callable and that the 3 risks are related to the asset, i.e. if interest rates fall, a 7% coupon bond held by the investor will be called and the investor can only reinvest in a 4% coupon bond.

 

[cipherap15]

No, thats why I’m confused. We’re funding the liability with Non Callable Bonds.

 

[cpk123]

question relates to risk the asset faces, and not with respect to how they are funded.
so based on the asset - it faces interest rate risk, contingent claim risk and cap risk.

 

[MrSmart]

If the risks are not matched, then you have it as a risk in either side. The liabilities might be contingent, floating, and mismatched in duration.

 

[gottabecfa]

I am also confused on this one.
The question states that the manager is using noncallable bonds to immunize a payment due in five years to fund the expansion of a hospital.
Can someone please explain specifically where contingent claim risk comes into play in this scenario? I guess I don’t understand how the liability is subject to contingent claim risk if it is already fully funded with a noncallable asset.

 

[cipherap15]

Ive asked other people about this and there seems to be quite a bit of confusion with regards to this question