Reading 25 Book 4 curriculum EOC # 27 - contingent claim ris only, concerned, continue, provided

prashantsahni

Hi All,
Question 27 on page 155 asks for the risks that the manager should be concerned about.
The manager’s immunization approach involves only non-callable bonds.  Yet the manager is concerned about contingent claim risk according to the solution provided in the curriculum.
I am not clear as to why the manager should continue to worry about contingent claim risk if he is only holding non-callable bonds.
Your response is much appreciated.
PS

SFoyil

interest rate risk, contingent claim risk and cap risk are the risks a manager should be concerned about WITH REGARDS TO PAYMENTS OF LIABILITIES. It does not matter how those liabilities are being financed on the side with assets.
Interest Rate Risk: Rate rises - due to a duration mismatch between assets and liabilties - the liabilties become harder to pay.
Contingent Claim Risk: is a risk when rates fall. MBS and other securities with embedded call options which are present in your liabilties portfolio may require to be paid immediately (due to refinancing).
Cap Risk: When rates rise - an asset that is present in your portfolio to meet liabilites schedules may get capped - and hence your assets are not present in enough quantity to pay your liabilities.

bkballa

It is not the assets ( his non-callable bonds ) that are subect to contingent claims risk.
It is the liabilities.
For example the funding for the new wing may have been partially through putable bond issues , which could be put back to the pension fund at a time when rates are rising , thus increasing future liability costs

ajpheif16

typically things like MBS. There could be other such items that face the risk.
Another situation - the surplus goes so negative that the entity goes bankrupt - and then the “contingent liabilties” need to be paid immediately.

wake2000

Hi Janakisri and CPK123,
Thank you both for additional examples.  My doublt is cleared up now.  Yoohoo.
PS

tarunajwani

These risks (interest rate, contingent claim, and cap risks) are that the assets are insuffucient to fund the liability. So this could come from either side of the equation (Higher Liabilities OR Lower Assets).
For interest rate risk it could mean a mismatch of duration. If int rates go up risk is that duration of liabilities is lower than that of assets, or if int rates go down risk is that duration of liabilities is higher than that of assets. For contingent claim risk it could mean HOLDING callable bonds or MBS type securities; or ISSUING puttable bonds. And cap risk could mean holding a floater that is capped on the upside, or issuing a floater with a floor - right?

Ionutzakis

I am trying to understand this: Wouldn’t change in int rates affect the duration of both liabliities and assets in the same direction?
“For interest rate risk it could mean a mismatch of duration. If int rates go up risk is that duration of liabilities is lower than that of assets, or if int rates go down risk is that duration of liabilities is higher than that of assets. “

busprof

duration is assumed constant . It is assumed not to change. The direction of exposure change is the same between assets and liabilities . For instance if rates drop assets increase in value while liabilities also increases in value . But you have a negative sign in front of liabilities ( to the pension fund )
Here we’re talking of liabilities which has a higher  duration than the benchmark. So a drop in rates is going to increase liabilities value more than the benchmark increase . So youre only making the net ALM gap wider.

studyn

Hi,
Seems some are trying to defend CFAI.
Lets summarize facts in the question.
# The project is fully funded
# ALL are NON-Callable bonds, no other bonds are involved
# Even these bonds are putable, the decision to excercise put option is on portfolio manager’s hand. So it is not a RISK
If anyone say  contingent risk exists here, please show at least ONE CONTINGENT even that can happen to bonds so that ability to meet liability is at a risk?

pogo

I have the same doubt, the cfa answer may be just a general answer.
One more question: which are eligible assets for immunization? Callable bonds are usually high yield bonds, and could default?