Applications—Liability Discounting and Cash Matching
Example 2.7
Extending the concept of this example, suppose a pension plan has liabilities that are expected to grow over time and wants to invest in bonds to provide the necessary cash flows against these future obligations. Suppose it does so at a time when yields are near historic lows. What, specifically, should the bond portfolio manager be concerned about with respect to interest rate risk beyond duration? (Hint: think convexity.)
Example 2.8
When regulation Q was lifted, savings & loans (S&Ls) suddenly found themselves competing with commercial banks for savings deposits. S&Ls’ balance sheets were dominated by long-term mortgage loans. Detail the changing landscape for S&L risk as a result of this deregulation. (Hint: the duration of liabilities and assets diverged.)
Example 2.9
Cash matching: let's add some realism to the pension problem. Suppose, as given, there are 10 bonds, ranging in maturity from a one-year zero to a six-year bond.
The coupons and cash flows are given in the following table.
Example 2.9 Table A
The market prices of the bonds are given in the second-to-last row. The pension has estimated its ...
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