Risk free of asset only approach and liability relative

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johntavv

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Reading 15, Linking Pension Liabilities to Assets, says:
In the asset-only approach, the risk-free investment is the return on cash. In a liability-relative approach, the risk free investment is a portfolio that is highly correlated with and mimics the liability in performance.
With the liability-relative approach, why is a highly correlated portfolio with the liability performance the risk-free? I though either cash or government securities would be risk-free?
 
highly correlated with liability - means it is earning close to the return expected on the liability. that way you have a net rate of (close to) zero = risk free.
that is a key point in most ALM (asset liability matching) scenarios. you want that to be the case so you do not have fluctuations between your assets and your liabilities - which reduces the risk of your portfolio.
 
Why wouldn’t the risk-free be a portfolio with correlation of -1 with the liability? So if the liability return goes down, your portfolio return (the one that has correlation of -1) goes up, and so net return is close to zero= risk free?
 
It may help to think of the liability as a short position in a bond with a term that matches that of your liability. The best way to offset the risk associated with the liability is to hold a long position in the same bond. This is what is meant by high correlation - it is the asset that matches your liability as close as possible. You are hedging the risk through holding a short and a long position in an asset (or two assets that are highly correlated) simultaneously.
 
johntavv wrote:Why wouldn’t the risk-free be a portfolio with correlation of -1 with the liability? So if the liability return goes down, your portfolio return (the one that has correlation of -1) goes up, and so net return is close to zero= risk free?
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It is: you get the negative sign by being long the assets and short the liabilities.
If you had, say, floating-rate liabilities and inverse floating-rate assets – so that when the coupon on your liabilities went down the coupon on your assets would go up and vice-versa – you’ll have huge volatility in your (overall: assets − liabilities) portfolio.
 
It is: you get the negative sign by being long the assets and short the liabilities.
What is meant by “long the assets and short the liabilities”?
I understand that floating rate liabilities and inverse floating rate assets are not offsetting positions, but don’t get the statement above.
Thanks
 
You want the value of your assets and the value of your liabilities to move together: assets up, liabilities up; assets down, liabilities down.
You get the “negative” part of “correlation of -1” because you are long the assets and short the liabilities: when the assets go up you gain, but when the liabilities go up you lose; when the assets go down you lose, but when the liabilities go down you gain.
 
I see, so if we want an offsetting position where:
we are long assets (if asset goes up we gain), and at the same time
we are short liabilities (if liability goes up we lose)
doesn’t that mean we want a correlation between the asset and liability of +1 (e.g. we want them to move together)? The previous responses say we want a -1 correlation.
 
you want your assets to go up. What you own should go up.
at the same time you want your liabilities to go down. What you owe should reduce.
I feel with my analogy above Assets up, Liabilities Down - so Correlation = -1.
So not sure - what S2000 meant when he said
Quote:
You want the value of your assets and the value of your liabilities to move together: assets up, liabilities up; assets down, liabilities down.
Click to expand...
 
johntavv wrote:I see, so if we want an offsetting position where:
we are long assets (if asset goes up we gain), and at the same time
we are short liabilities (if liability goes up we lose)
doesn’t that mean we want a correlation between the asset and liability of +1 (e.g. we want them to move together)? The previous responses say we want a -1 correlation.
Click to expand...
To be risk-free, yes: we want them to move together.
 
cpk123 wrote:you want your assets to go up. What you own should go up.
at the same time you want your liabilities to go down. What you owe should reduce.
I feel with my analogy above Assets up, Liabilities Down - so Correlation = -1.
So not sure - what S2000 meant when he said
Quote:
You want the value of your assets and the value of your liabilities to move together: assets up, liabilities up; assets down, liabilities down.
Click to expand...
Click to expand...
He was trying to answer the original question: risk-free.
 
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