Asset/liability management and the use of risk buckets

For asset/liability managers, the recommendations are again quite similar. One
should focus on immunizing parallel risk (duration) and slope risk. If these two risk
factors are well matched, then from an economic point of view the assets are an
effective hedge for the liabilities. Key rate durations are a useful way to measure
exposure to individual points on the yield curve; but it is probably unnecessary to
match all the key rate durations of assets and liabilities precisely. However, one does
need to treat both the short and the very long end of the yield curve separately.
Regarding the long end of the yield curve, it is necessary to ensure that really longdated
liabilities are matched by similarly long-dated assets. For example, one does
not want to be hedging 30-year liabilities with 10-year assets, which would be
permitted if one focused only on parallel and slope risk. Thus, it is desirable to
ensure that 10-year to 30-year key rate durations are reasonably well matched.
Regarding the short end of the yield curve, two problems arise. First, for maturities
less than about 18–24 months – roughly coinciding with the liquid part of the
Eurodollar futures strip – idiosyncratic fluctuations at the short end of the curve
introduce risks additional to parallel and slope risk. It is safest to identify and hedge
these separately, either using duration bucketing or partial durations.
Second, for maturities less than about 12 months, it is desirably to match actual
cashflows and not just risks. That is, one needs to generate detailed cashflow
forecasts rather than simply matching interest rate risk measures.
To summarize, an efficient asset/liability management policy might be described as
follows: from 0–12 months, match cash flows in detail; from 12–24 months, match
partial durations or duration buckets in detail; from 2–15 years, match parallel and
slope risk only; beyond 15 years, ensure that partial durations are roughly matched too.
Finally, one must not forget optionality. If the assets have very different option
characteristics from the liabilities – which may easily occur when callable bonds or
mortgage-backed securities are held – then it is not sufficient to match interest rate
exposure in the current yield curve environment. One must also ensure that risks
are matched under different interest rate and volatility scenarios. Optionality is
treated in detail elsewhere in this book.
In conclusion: principal component analysis suggests a simple and attractive solution to the problem of efficiently managing non-parallel yield curve risk. It is
easy to understand, fairly easy to implement, and various off-the-shelf implementations
are available. However, there are quite a few subtleties and pitfalls involved.
Therefore, risk managers should not rush to implement policies, or to adopt vendor
systems, without first deepening their own insight through experimentation and
reflection.