Yield Curve Flattens short

Chuckrox8

Can somebody explain for a Pension with:

Duration Assets: 5.6
Duration Liabilities: 10.2

How a flattening yield curve is the worst case scenario?

I understand how a parallel shift up would be beneficial for the surplus as liabilities decrease more than assets, and if its a parallel shift downward this is bad for surplus, as liabilities increase more than assets...

But the flattening is still confusing... what if short end comes up and long end stays put, or long end comes down and short end stays put? Or lastly, if both short rates move upward and long rates come down....

aidebaobao

Your liabilities go up in value more than your assets on the long end.

The long end dominates the overall effect because duration is greater.

NO EXCUSES

justin88

Either

bull flattener where long ends move down. Really bad. Now PV of liabilities much higher than PV of assets

bear flattener where PV of liabilities stays fixed but PV of assets decreases.

Flattening is bad because in the end liabilities under both circumstances have market value changes greater than assets changes.



Edited 1 time(s). Last edit at Wednesday, June 1, 2011 at 02:49PM by Paraguay.

Chuckrox

Another way of looking at this is.....

Your asset liability duration mismatch is good for you as long as the yield curve stay upward sloping or gets even steeper. Your liabilities will lose more value than your assets and your surplus will increase.

However, if the yield curve starts to flatten( rates start to fall, in simplistic terms), your liabilities will grow faster than your assets due to higher durations leading to a shrinking surplus.

bpdulog

Short end rates go up, your assets get burned, liabilities don't

Tail end rates go down, liabilities increase, assets don't (so much)

Although simplified, aggregate duration implies the horizon of the asset or liability - so in this case, if short term rates go up, long term rates go down, look at the liabilities.