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[CFAI EOC - SS10 R22] Question 27 possible error with contingent claim risk?

Hi guys @Jwa‌ @RaviVooda‌ @AjFinance‌ @Alta12‌ hope your studies been going well, I need your views on this very question.


Text:

"In addition to his CIO responsibilities, Choo is also responsible for managing the funding liabilities for a new wing at the local hospital, which is currently fully funded utilising a standard immunization approach with noncallable bonds. However, he is concerned about the various risks associated with the liabilities including interest rate risk, contingent claim risk, and cap risk."

Question 27:
Are Choo's concern regarding various risk of funding the hospital liability correct?
A Yes
B. No, because interest rat risk is not a factor.
C. No, because contingent claim risk is not a factor.

Answer: A is correct. Cap risk, interest rate risk and contingent claim risk are all risks to the portfolio manager faces.


My answer however is C. Since the immunisation approach with noncallable bonds, doesn't that mean there's no risk of the bonds being called when the interest rates fall, hence there should not be any contingent claim risk (a.k.a. call risk). Please correct my understanding here, thanks.

Comments

  • @vincentt I got tripped up at first with this question too. C would have been correct if the question was asking '...Choo is concerned about the various risks associated with the funding of the liabilities (which is really the assets)...'. However, the question is asking about the various risks associated with the liabilities. As no specifics are given about the liabilities itself, then in a general sense the PM faces interest rate risk, contingent claim risk and cap risk (reference CFAI R20 p.38).

    I think the question is badly worded. I'm interested in other's thoughts.
    AjFinance
  • @Alta12‌ I thought the question is asking about the risk with funding the hospital's liabilities which is currently fully funded with the standard immunisation approach. As far as I know, that means they have purchased bonds that matches the liabilities of funding the hospital and these bonds are not callable which means the issuer are not able to call the bond if the rates were to fall. I would think A is right if they did not mention 'non callable bonds'.

    What do you reckon?
  • @vincent‌t, @‌

    1. My understanding of contingent claims is that they are the claims that are triggered when any specific event(s) occur. So callable/non callable does not matter here.
    2. Even though the liabilities are fully immunized it still has the risk of non parallel interest rate shifts for standard immunization. Also since immunization is not a set and forget approach, we should be vary of the interest rate changes.

    Please correct me if I am wrong
  • @RaviVooda‌ that definitely makes sense! Thanks so much. Just one more question, what do you think about cap risk?

    Would that even be relevant ?
  • @vincentt, For cap risk I am a bit confused. We have cap risk when we have floating rate bonds and the problem arises when we have floating rate liability, because on one hand we pay more and the other hand payments are capped.

    I feel that that there is no cap risk here. @Alta12 what do you think?
  • @ravivooda as far as i'm aware there shouldn't be a cap risk as capping is good for liabilities so you don't have to pay more when the rate goes up.

    Btw, when they mention liabilities does it always refer to a bond or it's just a liability? Because the way i see it is how cap can be a risk is when the liability they are referring to is a bond and when rate goes up you are expecting the price to go down but it's capped.

  • @vincentt‌, what I meant is when you have a liability where you are paying at floating rate, and you are paying that liability from another floating rate bond which has a cap, there is a risk. Because the amount you are paying does not match the amount you receive when there is a cap.

    I am not refering liability to any bond.
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