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Extension of traditional MVO
The ALM perspective focuses on the surplus efficient frontier. Mean-variance surplus optimization extends traditional MVO to incorporate the investors’ liabilities
What’s funding ratio?
The funding ratio, calculated by dividing the value of pension assets by the present value of pension liabilities
If the funding ratio exceeds 100%, the pension fund is overfunded
If the funding ratio is less than 100%, the pension fund is underfunded
If the funding ratio equals to 10%, the pension fund is exactly fully funded
The usage of Monte Carlo simulation of ALM
Monte Carlo simulation can help confirm that the recommended allocations provide sufficient diversification and to evaluate the probability of funding shortfalls, the likelihood of breaching return thresholds and the growth of assets with and without disbursements from the portfolio
A simple asset allocation approach that blends surplus optimization with Monte Carlo simulation follow below steps
Determine the surplus efficient frontier and select a limited set of efficient portfolios, from the MSV portfolio to higher-surplus-risk portfolios, to examine further.
Conduct a Monte Carlo simulation for each proposed asset allocation and evaluate which. allocations, if any, satisfy the investor’s return and risk objectives.
Choose the most appropriate allocation that satisfies those objectives.
Immunization strategies
Immunization is a popular strategy for locking in a guaranteed rate of return over a particular time horizon
The purpose of immunization is to identify the portfolio for which the change in price is exactly equal to the change in reinvestment income at the time horizon of interest
The fundamental mechanism supporting immunization is a portfolio structure that balances the change in the value of the portfolio at the end of the investment horizon with the return from the reinvestment of portfolio cash flows (coupon payments and maturing securities).
What’s static spread, zero volatility spread
Defined as the constant spread above the treasury spot curve that equates the calculated price of security to the market price
What’s OAS?
The current spread over the benchmark yield minus the component of the spread that is attributable to any embedded optionality in the instrument
When contingent immunization is possible?
Contingent immunization is possible when the prevailing available immunized rate of return is greater than the required rate of return
What’s cushion spread
The difference between minimum acceptable return and the higher posible immunized rate
Reinvestment risk determines immunization risk
The portfolio that has least reinvestment risk will have the least immunization risk
