Chapter24

Indexing

24-1Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallLearningObjectivesAfterreadingthischapter,youwillunderstandtheobjectivesandmotivationforbondindexingtheadvantagesanddisadvantagesofbondindexingthethreemajorbroad-basedbondmarketindexesthesectorsofthebroad-basedindexesthethreemethodologiesusedforconstructinganindexedportfolio24-2Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallLearningObjectives

(continued)Afterreadingthischapter,youwillunderstandthedifficultiesassociatedwithimplementingabondindexingstrategytheobjectivesandmotivationforenhancedbondindexingthestrategiesusedinenhancedindexing24-3Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallObjectiveofandMotivationforBondIndexingBondindexingmeansdesigningaportfoliosothatitsperformancewillmatchtheperformanceofsomebondindex.Inindexing,performanceismeasuredintermsoftotalrateofreturnachieved(orsimply,totalreturn)oversomeinvestmenthorizon.Totalreturnoversomeinvestmenthorizonincorporatesallsourcesofreturnfromholdingaportfolioofbonds.24-4Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallObjectiveofandMotivationforBondIndexing(continued)Severalfactorsexplainthepopularityofbondindexing.First,theempiricalevidencesuggeststhathistoricallytheoverallperformanceofactivebondmanagershasbeenpoor.Secondisthereducedadvisorymanagementfeeschargedforanindexedportfoliocomparedtoactivemanagementadvisoryfees.Lowernonadvisoryfeesareathirdexplanationforthepopularityofindexing.24-5Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallObjectiveofandMotivationforBondIndexing(continued)Advisoryfeeschargedbyactivemanagerstypicallyrangefrom15to50basispoints.Therangeforindexedportfolios,incontrast,is1to20basispoints,withtheupperrangerepresentingthefeesforenhancedandcustomizedbenchmarkfunds,discussedlaterinthischapter.24-6Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallObjectiveofandMotivationforBondIndexing(continued)Sponsorshavegreatercontroloverexternalmanagerswhenanindexingstrategyisselected.Forexample,inanactivelymanagedportfolio,asponsorwhospecifiesarestrictionontheportfolio’sdurationstillgivesthemanagerampleleewaytopursuestrategiesthatmaysignificantlyunderperformtheindexselectedasabenchmark.Incontrast,requiringaninvestmentadvisortomatchanindexgiveslittleleewaytothemanagerand,asaresult,shouldresultinperformancethatdoesnotsignificantlydivergefromabenchmark.24-7Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallObjectiveofandMotivationforBondIndexing(continued)Criticsofindexingpointoutthatalthoughanindexingstrategymatchestheperformanceofsomeindex,theperformanceofthatindexdoesnotnecessarilyrepresentoptimalperformance.Moreover,matchinganindexdoesnotmeanthatthemanagerwillsatisfyaclient’sreturnrequirementobjective.Matchinganindexmeansthatamoneymanagerisrestrictedtothesectorsofthebondmarketthatareintheindex,eventhoughtheremaybeattractiveopportunitiesinmarketsectorsexcludedfromtheindex.24-8Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallObjectiveofandMotivationforBondIndexing(continued)Atthetheoreticallevel,therearethewell-knownbenefitsofdiversificationassetforthintheMarkowitzmean-varianceportfoliotheory.Capitalmarkettheorytellsusamarketportfoliooffersthehighestlevelofreturnperunitofriskinanefficientmarket.Themarketportfolioisacapitalization-weighted(value-weighted)portfolioofallriskyassets.Exhibit24-1(seeOverhead24-10)summarizestheadvantagesanddisadvantagesofbondindexing.24-9Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallExhibit24-1AdvantagesandDisadvantagesofBondIndexingAdvantagesDisadvantagesNodependenceonexpectationsandlittleriskofunderperformingtheindexBondindexesdonotreflectoptimalperformanceReducedadvisoryandnonadvisoryfeesBondindexmaynotmatchthesponsor’sliabilitiesGreatersponsorcontrolRestrictionsonfund;managementignoresopportunities24-10Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallFactorstoConsiderinSelectinganIndexAmoneymanagerwhowishestopursueanindexingstrategymustdeterminewhichbondindextoreplicate.Thereareanumberofbondindexesfromwhichtoselect,andseveralfactorsinfluencethedecision.Thefirstistheinvestor’srisktolerance.Thesecondfactorinfluencingtheselectionofanindexistheinvestor’sobjective.24-11Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallBondIndexesThewiderangeofbondmarketindexesavailablecanbeclassifiedasbroad-basedmarketindexesandspecializedmarketindexes.Broker/dealerfirmsdevelopedandaggressivelymarketedtheirbondindexesbecauseofthepotentialprofitthatthefirmwillmakebyexecutingtradestosetupanindexedportfolioandrebalanceit.Typically,abroker/dealerchargesamoneymanagerwhowantstosetuporrebalanceanindexanominalamountforprovidingthenecessarydatabutexpectsthatthebulkofthetradeswillbeexecutedthroughitstradingdesks.24-12Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallBondIndexes(continued)Thetwobroad-basedU.S.bondmarketindexesmostcommonlyusedbyinstitutionalinvestorsaretheLehmanBrothersU.S.AggregateBondIndextheSalomonSmithBarney(SSB)BroadInvestment-GradeBondIndex(BIG)Therearemorethan5,500issuesinallthreebroad-basedindexes.Theyincludeonlyinvestment-gradesecurities.Eachindexisamarket-valueweightedindex.Thepricingofthesecuritiesineachindexisasfollows.ThesecuritiesintheSSBBIGindexarealltraderpriced.Forthetwootherindexes,thesecuritiesareeithertraderpricedormodelpriced.Eachindexisbrokenintosectors.24-13Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallBondIndexes(continued)FortheLehmanBrothersU.S.AggregateBondIndex,theagencysectorincludesagencydebentures,notmortgage-backedorasset-backedsecuritiesissuedbyfederalagencies.Themortgagepass-throughsectorincludesagencypass-throughsecurities.Whatarenotincludedintheindexareagencycollateralizedmortgageobligationsandagencystrippedmortgage-backedsecurities.Thesemortgagederivativesproductsarenotincludedbecauseitwouldbedoublecountingsincetheyarecreatedfromagencypass-throughs.24-14Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologiesAfteramoneymanagerhasdecidedtopursueanindexingstrategyandhasselectedanindex(broad-basedbondmarketindex,specializedmarketindex,orcustomizedbenchmark),thenextstepistoconstructaportfoliothatwilltracktheindex.Anydiscrepancybetweentheperformanceoftheindexedportfolioandtheindex(whetherpositiveornegative)isreferredtoastrackingerror.Trackingerrorhasthreesources:transactioncostsinconstructingtheindexedportfoliodifferencesinthecompositionoftheindexedportfolioandtheindexitselfdiscrepanciesbetweenpricesusedbytheorganizationconstructingtheindexandtransactionpricespaidbytheindexer24-15Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologies

(continued)Generallyspeaking,thefewerthenumberofissuesusedtoreplicatetheindex,thesmallerthetrackingerrorduetotransactionscostsbutthegreaterthetrackingerrorriskduetothemismatchofthecharacteristicsoftheindexedportfolioandtheindex.Incontrast,themoreissuespurchasedtoreplicatetheindex,thegreaterthetrackingerrorduetotransactioncostsandthesmallerthetrackingerrorriskduetothemismatchoftheindexedportfolioandtheindex.Obviously,then,thereisatrade-offbetweentrackingerrorandthenumberofissuesusedtoconstructtheindexedportfolio.24-16Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologies

(continued)Therearethreemethodologiesfordesigningaportfoliotoreplicateanindex:thestratifiedsamplingorcellapproachtheoptimizationapproachthevarianceminimizationapproachEachapproachassumesthattheperformanceofanindividualbonddependsonanumberofsystematicfactorsthataffecttheperformanceofallbondsandonafactoruniquetotheindividualissue.24-17Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologies

(continued)StratifiedSamplingorCellApproachUnderthestratifiedsamplingapproachtoindexing,theindexisdividedintocells,eachcellrepresentingadifferentcharacteristicoftheindex.Themostcommoncharacteristicsusedtobreakdownanindexare:durationcouponmaturitymarketsectors(Treasury,corporate,mortgage-backed)creditratingcallfactorssinkingfundfeaturesThelasttwofactorsareparticularlyimportantbecausethecallandsinkingfundfeaturesofanissuewillaffectitsperformance.24-18Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologies

(continued)StratifiedSamplingorCellApproachSupposethatamanagerselectsthefollowingcharacteristicstopartiteinaTreasury/agency/corporatebondindex:Characteristic1:effectivedurationrange:(1)lessthanorequaltofiveyears,and(2)greaterthanfiveyearsCharacteristic2:maturityrange:(1)lessthanfiveyears,(2)betweenfiveand15years,and(3)greaterthanorequalto15yearsCharacteristic3:marketsectors:(1)Treasury,(2)agencies,and(3)corporatesCharacteristic4:creditrating:(1)AAA,(2)AA,(3)A,and(4)BBBThetotalnumberofcellswouldbeequalto2x3x3x4=72.24-19Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologies

(continued)StratifiedSamplingorCellApproachTheobjective,then,istoselectfromalltheissuesintheindexoneormoreissuesineachcellthatcanbeusedtorepresenttheentirecell.Thetotaldollaramountpurchasedoftheissuesfromeachcellwillbebasedonthepercentageoftheindex’stotalmarketvaluethatthecellrepresents.Forexample,if40%ofthemarketvalueofalltheissuesintheindexismadeupofcorporatebonds,40%ofthemarketvalueoftheindexedportfolioshouldbecomposedofcorporatebondissues.24-20Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologies

(continued)StratifiedSamplingorCellApproachThenumberofcellsthattheindexeruseswilldependonthedollaramountoftheportfoliotobeindexed.Inindexingaportfoliooflessthan$50million,forexample,usingalargenumberofcellswouldrequirepurchasingoddlotsofissues.Thisincreasesthecostofbuyingtheissuestorepresentacellandthuswouldincreasethetrackingerror.Reducingthenumberofcellstoovercomethisproblemincreasestrackingerrorriskofindexmismatchbecausethecharacteristicsoftheindexedportfoliomaydiffermateriallyfromthoseoftheindex.24-21Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologies

(continued)OptimizationApproachIntheoptimizationapproachtoindexing,

themoneymanagerseekstodesignanindexedportfoliothatwillmatchthecellbreakdownandsatisfyotherconstraints,butalsooptimizesomeobjective.Anobjectivemightbetomaximizetheportfolioyield,tomaximizeconvexity,ortomaximizeexpectedtotalreturns.Constraintsotherthanmatchingthecellbreakdownmightincludenotpurchasingmorethanaspecifiedamountofoneissuerorgroupofissuers,oroverweighingcertainsectorsforenhancedindexing.24-22Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallIndexingMethodologies

(continued)TrackingErrorMinimizationusingMultifactorRiskModelsAportfoliocanbeconstructedsuchthatitsforward-lookingtrackingerrorisminimized.Vendorsofmulti-factorriskmodelsprovidesoftwarethatpermitstheconstructionofaportfoliothatwillaccomplishtrackingerrorminimization.Theforward-lookingtrackingerrorforeachsecurityincludedintheindexisobtainedfromastatisticalanalysisofhistoricalreturns.24-23Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallLogisticalProblemsinImplementinganIndexingStrategyAnindexerfacesseverallogisticalproblemsinconstructinganindexedportfolio.First,thepricesforeachissueusedbytheorganizationthatpublishestheindexmaynotbeexecutionpricesavailabletotheindexer.Second,therearelogisticalproblemsuniquetocertainsectorsinthebondmarket.24-24Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallLogisticalProblemsinImplementinganIndexingStrategy(continued)Considerthecorporatebondmarket.Becauseoftheilliquidityofthissectorofthebondmarket,notonlymaythepricesusedbytheorganizationthatpublishestheindexbeunreliable,butmanyoftheissuesmaynotevenbeavailable.Also,forthemortgage-backedsecuritiesmarket,theorganizationsthatpublishindexeslumpalltheseissuesintoafewhundredgenericissues.Theindexeristhenfacedwiththedifficulttaskoffindingpass-throughsecuritieswiththesameriskreturnprofilesofthesehypotheticalissues.24-25Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallLogisticalProblemsinImplementinganIndexingStrategy(continued)Recallthatthetotalreturndependsonthereinvestmentrateavailableoncouponinterest.Iftheorganizationpublishingtheindexregularlyoverestimatesthereinvestmentrate,theindexedportfoliocouldunderperformtheindexby10to15basispointsayear.24-26Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallEnhancedIndexingTheobjectiveofanenhancedindexingstrategyistoreplicatethetotalreturnperformanceofsomepredeterminedindex.Inenhancedindexing(alsocalled“indexingplus”),theobjectiveisconsistentlytoexceedthetotalreturnperformanceoftheindexbyanamountsufficienttojustifyahighermanagementadvisoryfeeandahigherlevelofriskofunderperformingtheindex.Thetotalreturnontheindexbecomestheminimumtotalreturnobjectiveratherthanthetargettotalreturn.Thusenhancedindexingbringsactivestrategiesbackintotheportfoliomanagementprocess,althoughtheyareassumedtoemployonlylow-riskstrategies.24-27Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallEnhancedIndexing(continued)Basically,anydepartureofaportfolio’scompositionfromthatofthebenchmarkrepresentstheriskexposureofaportfolio.Inplainvanillaindexing,theportfoliomanagerattemptstoreplicatethebenchmarkindexasbestaspossiblesubjecttothelimitationsdiscussedearlierregardingimplementation.Inenhancedindexing,thereisacontrolleddepartureoftheportfolio’scompositionfromthatofthebenchmarkindex.Asthedeparturefromthebenchmarkindexbecomesgreater,theportfoliomanagercrossesoverintotheareaofactivemanagement.Justwherethatcrossoveroccursdiffersfrommanagertomanager.24-28Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallEnhancedIndexing(continued)Anotherwaytodefineenhancedindexingisintermsoftrackingerror.Whilethereisnoindustrystandard,KennethVolpert,principalandseniorportfoliomanageratTheVanguardGroup,feelsthatundernormalconditionsatrackingerrorofoneto15basispointsperyearisreasonable.However,samplingriskhasincreasedinrecentyearsascorporateissuer“blow-ups”haveoccurredwithgreaterfrequencyandwithgreaterdownside,whichhasresultedinactualtrackingerrorbeinggreaterthanmodelpredictedtrackingerror.Manymulti-factorriskmodelsarebeingrecalibratedtocapturethisgreateridiosyncraticcreditrisk.Forenhancedbondindexing,trackingerrorrangesfrom15to50basispointsundernormalconditions.Therangeinthetrackingerrorisduetothewiderangeofenhancedindexingportfoliostrategiesthatcanbepursued.24-29Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallEnhancedIndexing(continued)AnyofthestrategiesemployedinenhancedindexingwouldinvolveonlythoseissuesintheIndex.Anotherstrategyforenhancingtotalreturnistousesecuritiesnotincludedintheindex.Forexample,thebroad-basedindexesdonotincludederivativemortgage-backedsecurities,suchascollateralizedmortgageobligations.Ifmoneymanagerspursuingenhancedindexstrategiesbelievethatderivativemortgage-backedsecuritieswilloutperformtheagencypass-throughsecuritiesintheindex,theycansubstitutetheformersecuritiesforthelatter.Orthemoneymanagermaybeabletocreatesyntheticagencypass-throughsecuritiesbyusingstrippedmortgage-backedsecurities(interest-onlyandprincipal-onlysecurities)thatwouldexhibitbetterperformanceincertaininterest-rateenvironments.24-30Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallAllrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmitted,inanyformorbyanymeans,electronic,mechanical,photocopying,recording,orotherwise,withoutthepriorwrittenpermissionofthepublisher.PrintedintheUnitedStatesofAmerica.24-31Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHall

Chapter25

Liability-DrivenStrategies

24-32Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHall25-33LearningObjectivesAfterreadingthischapter,youwillunderstandthetypesofliabilitiesthataninstitutionmayfacethetwoimportantdimensionsofaliability:theamountandtimingofthepaymentwhythesamefactorsthataffecttheriskoffinancialassetsalsoaffectliabilitiesthegoalsofasset/liabilitymanagementthedifferencebetweenaninstitution’saccountingsurplus,regulatorysurplus,andeconomicsurplushowassetsarehandledforaccountingpurposeshowtousethedurationofassetsandliabilitiestocalculatethesensitivityoftheeconomicsurplusofaninstitutionwheninterestrateschangewhataliability-drivenstrategyistherisksassociatedwithmismatchingportfolioassetsandliabilitieswhatimmunizingaportfoliois24-33Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallLearningObjectives(continued)Afterreadingthischapter,youwillunderstandthebasicprinciplesofanimmunizationstrategyandtheroleofdurationinanimmunizationstrategytherisksassociatedwithimmunizingaportfoliowhatacontingentimmunizationstrategyisandthekeyfactorsinimplementingsuchastrategythetwoliability-drivenstrategieswhentherearemultipleliabilities:multiperiodliabilityimmunizationandcashflowmatchingtheadvantagesanddisadvantagesofamultipleliabilityimmunizationstrategyversusacashflowmatchingstrategyhowliabilityfundingstrategiescanbeextendedtocasesinwhichtheliabilitiesarenotknownwithcertaintywhatanactive/immunizationcombinationstrategyisliability-drivenstrategiesfordefinedbenefitpensionplans24-34Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagementClassificationofLiabilitiesAliability

isacashoutlaythatmustbemadeataspecifictimetosatisfythecontractualtermsofanissuedobligation.Aninstitutionalinvestorisconcernedwithboththeamountandtimingofliabilities,becauseitsassetsmustproducethecashtomeetanypaymentsithaspromisedtomakeinatimelyway.Infact,liabilitiesareclassifiedaccordingtothedegreeofcertaintyoftheiramountandtiming,asshowninExhibit25-1(seeOverhead25-5).Theclassificationassumesthattheholderoftheobligationwillnotcancelitpriortoanactualorprojectedpayoutdate.24-35Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallExhibit25-1ClassificationofLiabilitiesofInstitutionalInvestorsLiabilityTypeAmountofCashOutlayTimingofCashOutlayIKnownKnownIKnownUncertainIIIUncertainKnownIVUncertainUncertain24-36Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagement(continued)ClassificationofLiabilitiesThedescriptionsofcashoutlaysaseitherknownoruncertainareundoubtedlybroad.Whenwerefertoacashoutlayasbeinguncertain,wedonotmeanthatitcannotbepredicted.Therearesomeliabilitiesforwhich“l(fā)awoflargenumbers”makesiteasiertopredictthetimingand/oramountofcashoutlays.Thisworkistypicallydonebyactuaries,butevenactuarieshavedifficultypredictingnaturalcatastrophes,suchasfloodsandearthquakes.Justlikeassets,therearerisksassociatedwithliabilitiesandsomeoftheserisksareaffectedbythesamefactorsthataffectassetrisks.24-37Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagement(continued)TypeILiabilityAtypeIliabilityisoneforwhichboththeamountandtimingoftheliabilitiesareknownwithcertainty.TypeIliabilities,however,arenotlimitedtodepositoryinstitutions.Amajorproductsoldbylifeinsurancecompaniesisaguaranteedinvestmentcontract(GIC).TypeIILiabilityAtypeIIliabilityisoneforwhichtheamountofcashoutlayisknownbutthetimingofthecashoutlayisuncertain.ThemostobviousexampleofatypeIIliabilityisalifeinsurancepolicy.24-38Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagement(continued)TypeIIILiabilityAtypeIIIliabilityisoneforwhichthetimingofthecashoutlayisknownbuttheamountisuncertain.Atwo-yearfloating-rateCDinwhichtheinterestrateresetsquarterlybasedonamarketinterestrateisanexample.TypeIVLiabilityAtypeIVliabilityisoneinwhichthereisuncertaintyastoboththeamountandtimingofthecashoutlay.Probablythemostobviousexamplesareinsurancepoliciesissuedbypropertyandcasualtyinsurancecompanies.24-39Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagement(continued)LiquidityConcernsBecauseofuncertaintyaboutthetimingand/ortheamountofthecashoutlays,aninstitutionmustbepreparedtohavesufficientcashtosatisfyitsobligations.Alsokeepinmindthattheentitythatholdstheobligationagainsttheinstitutionmayhavetherighttochangethenatureoftheobligation,perhapsincurringapenalty.Inadditiontouncertaintyaboutthetimingandamountofthecashoutlaysandthepotentialforthedepositororpolicyholdertowithdrawcashearlyorborrowagainstapolicy,aninstitutionhastobeconcernedwithpossiblereductionincashinflows.Inthecaseofadepositoryinstitution,thismeanstheinabilitytoobtaindeposits.24-40Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagement(continued)SurplusManagementThetwogoalsofafinancialinstitutionaretoearnanadequatereturnonfundsinvested,andtomaintainacomfortablesurplusofassetsbeyondliabilities.Thetaskofmanagingfundsofafinancialinstitutiontoaccomplishthesegoalsisreferredtoasasset/liabilitymanagementorsurplusmanagement.Institutionsmaycalculatethreetypesofsurpluses:economic,accounting,andregulatory.Themethodofvaluingassetsandliabilitiesgreatlyaffectstheapparenthealthofafinancialinstitution.Unrealisticvaluation,althoughallowableunderaccountingproceduresandregulations,isnotsoundinvestmentpractice.24-41Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagement(continued)SurplusManagementTheeconomicsurplusofanyentityisthedifferencebetweenthemarketvalueofallitsassetsandthemarketvalueofitsliabilities;thatis,theeconomicsurpluscanbeexpressedas

economicsurplus=marketvalueofassets–presentvalueofliabilitiesIfinterestratesrise,boththeassetsandliabilitiesdecline,sotheeconomicsurpluscanincrease,decrease,ornotchange.Ifthedurationoftheassetsisgreaterthanthedurationoftheliabilities,theeconomicsurpluswillincreaseifinterestratesfall.Theneteffectonthesurplusdependsonthedurationorinterest-ratesensitivityoftheassetsandliabilities,soitisimperativethatportfoliomanagersbeabletomeasurethissensitivityforallassetsandliabilitiesaccurately.24-42Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagement(continued)SurplusManagementAccountingsurplusissurplusofassetsoverliabilitiesasreportedinfinancialstatementsbasedongenerallyacceptedaccountingprinciples(GAAP)accounting.Institutionalinvestorsmustprepareperiodicfinancialstatementsthatincludethereportingofassetsandliabilities.Withrespecttothefinancialreportingofassets,therearethreepossiblemethodsforreporting:amortizedcostorhistoricalcost,marketvalue,orthelowerofcostormarketvalue.FASB115specifieswhichofthesethreemethodsmustbefollowedforassets.Specifically,theaccountingtreatmentrequiredforasecuritydependsonhowthesecurityisclassified.24-43Copyright?2010PearsonEducation,Inc.PublishingasPrenticeHallGeneralPrinciplesofAsset/LiabilityManagement(continued)SurplusManagementTherearethreeclassificationsofinvestmentaccounts:heldtomaturity,availableforsale,andtrading.Theheld-to-maturityaccountincludesassetsthattheinstitutionplanstoholduntiltheymature.Anassetisclassifiedasintheavailable-for-saleaccountiftheinstitutiondoesnothavetheabilitytoholdtheassettomaturityorintendstosellit.Anassetthatisacquiredforthepurposeofearningashort-termtradingprofitfrommarketmovement