A classification of structured bond portfolio modeling techniques

TLDR: The various approaches to modeling the assethability management problem are examined to help practitioners decide which methodology is appropriate for their specific problem, given the unique structure of their liabilities and the types of assets in their portfolio.

Abstract: 0 ver the past decade, managing interest rate risk has become-a pivotal component of the portfolio management procedures of financial institutions. The volatility of interest rates in the early 1980s emphasized the importance of insulating portfolio values from unanticipated swings in interest rates. A flurry of activity contributed considerable refinements to existing assethability management techniques, including immunization techniques such as dedication and duration matching. This article examines the various approaches to modeling the assethability management problem. Our goal is to help practitioners decide which methodology is appropriate for their specific problem, given the unique structure of their liabilities and the types of assets in their portfolio. We consider a hypothetical financial institution with liabilities that must be met over time. To minimize financial risk, the institution intends to invest cash in assets that "match" the liabilities. The asset/ liability management problem is to identify a portfolio of assets (or to identify a feasible asset portfolio rebalancing strategy) that achieves this "match" so as to eliminate the interest rate risk from the combined assetniability portfolio. We classify assetniability problems as either deterministic or stochastic. Deterministic assethability problems are those for which 1) the liability cash flow stream is known with certainty in advance, and 2) the cash flows for all assets that may potentially be included in the portfolio are known with certainty, and do not depend in any way on factors such as the level ofinterest rates, exchange rates, or the general level of the economy. These two criteria are quite restrictive, excluding most realistic assethability management problems. All other problems are classified as stochastic problems; either the liability cash flows are uncertain, the asset cash flows are uncertain, or, in most instances, both. Much of the research in this area during the past decade has focused on analyzing the stochastic assetniability management problem. We also classify asset/liability management techniques according to the hedging criteria applied dedication techniques and duration-matching techniques. Dedication or cash-matching techniques focus on matching the liability cash flows over time. Duration-matching techniques focus on hedging the interest rate exposure in the liabilities by constructing an asset portfolio that matches the interest rate sensitivity of the liabilities. Table 1 categorizes assetniability management problems by problem type (deterministic or stochastic) and by hedging methodology (dedication or duration matching). Within each category, some references are provided to the literature. We discuss