Chapter 4

target to determine the optimal long-term asset allocation

-> comparable to industrial corporation strategic planning

3 ALM concepts:

1. duration matching

2. cashflow matching

3. Makrovitz with shortfall constraints

1. Investors objectives

2. Investors liability structure

3. regulation & other constraints

4. financial market behavior

5. risk

Strategy in which the duration of assets is managed so it matches the duration of liabilities

-> making the portfolio immune against interest rate changes, because both sides have an asymmetrical exposure to interest rate change

(liabilities are future pension payments)

(duration is weighted average timing of cashflow)

assets are structured such that the pension payments are equal to cash flows generated by asset base

-> i.d.R. bei only bond investments

1. high cost of pension plan if only bond investment

2. pension payments (cash outflows) are only rough estimates

3. not only high quality government bonds -> cash inflow becomes stochastic

• optimization problem is typically characterized by non-normal distributions, non-market book returns

• volatility is based on historical data -> in case of crisis behavior is unsure

1. tool should reflect accounting rules

2. multi-period rather than one-period

3. stochastic

4. dynamic

-> tool should be flexible and transparent

1. modeling of the institution with all features on basis of a stochastic simulation model

2. define target variable and desired distributions toghether with management

3. requires extensive research and a comprehensive data base

4. modeling of accounting rules

5. tool includes stochastic asset return-generator

   
   

1. strategic planning (& asset liability-analysis) -> strategic asset allocation, policy statement, risk philosophy, risk controlling measures

2. make or buy, active or passive and manager selection decision

3. controlling (objectives met, manager performance & quality) -> correcting measures

Bonds:

-> economic model of yield curve developed over time which can forecast

(interest rate levels over time & bond market returns)

asset returns are stochastic & based on non-normal fat tailed distributions

1. no exploitable inefficiences -> investor employs passive managers

2. exploitable inefficiencies

   2.1. high degree of confidence finding successful manager -> investor employs active managers

   2.2. low degree of confidence finding systematic outperformers -> investor employs passive managers

   2.3. some confidence finding outperformers -> Mix of active & passive management (Core-satellite-strategy)

large part of fund is invested passively

-> identification of market segments with a higher degree of inefficiency & appropriate manager -> active investment

(Diversification between managers, styles, sizes & regions)

goal is to construct a portfolio that closely resembles the respecrtive index at appropriate level of cost

-> conflicting goals: low tracking error vs. low cost

1. full replication -> composition of portfolio = index composition (TE = 0)

2. Sampling: Minimizing TE to given number of stocks (purchase of subset of index stocks) -> TE > 0

3. Stratified sampling: structure of passive portfolio resembles incex sturcture (e.g. country, industry, valuation) -> TE > 0

   (nicht unbedingt gleiche Titel wie im Index, nur gleiche Struktur)