Chapter 25Liability-Driven Strategies 1Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall25-2Learning ObjectivesAfter reading this chapter, you will understandvthe types of liabilities that an institution may face vthe two important dimensions of a liability: the amount and timing of the payment vwhy the same factors that affect the risk of financial assets also affect liabilities vthe goals of asset/liability management vthe difference between an institutions accounting surplus, regulatory surplus, and economic surplus vhow assets are handled for accounting purposes vhow to use the duration of assets and liabilities to calculate the sensitivity of the economic surplus of an institution when interest rates change vwhat a liability-driven strategy is vthe risks associated with mismatching portfolio assets and liabilities vwhat immunizing a portfolio is2Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallLearning Objectives (continued)After reading this chapter, you will understandv the basic principles of an immunization strategy and the role of duration in an immunization strategy v the risks associated with immunizing a portfolio v what a contingent immunization strategy is and the key factors in implementing such a strategy v the two liability-driven strategies when there are multiple liabilities: multiperiod liability immunization and cash flow matching v the advantages and disadvantages of a multiple liability immunization strategy versus a cash flow matching strategy v how liability funding strategies can be extended to cases in which the liabilities are not known with certainty v what an active/immunization combination strategy is v liability-driven strategies for defined benefit pension plans3Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallGeneral Principles of Asset/Liability Managementv 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. In fact, liabilities are classified according to the degree of certainty of their amount and timing, as shown in Exhibit 25- 1 (see Overhead 25-5). The classification assumes that the holder of the obligation will not cancel it prior to an actual or projected payout date.4Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallExhibit 25-1 Classification of Liabilities of Institutional InvestorsLiability TypeAmount of Cash OutlayTiming of Cash OutlayIKnownKnownIKnownUncertainIIIUncertainKnownIVUncertainUncertain5Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallGeneral Principles of Asset/Liability Management (continued)v Classification of Liabilities 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. This work is typically done by actuaries, but even actuaries have difficulty predicting natural catastrophes, such as floods and earthquakes. Just like assets, there are risks associated with liabilities and some of these risks are affected by the same factors that affect asset risks.6Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallGeneral Principles of Asset/Liability Management (continued)v Type I Liability 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 (GIC). v Type II Liability 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.7Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallGeneral Principles of Asset/Liability Management (continued)v Type III Liability 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. v Type IV Liability 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.8Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallGeneral Principles of Asset/Liability Management (continued)v Liquidity Concerns Beca