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This discussion delves into the concept of risk-free curves in fixed income portfolio management. It challenges the notion that a truly risk-free curve exists and questions the regulator's role in prescribing investment strategies. The text explores basis risk quantification, the dilemma between government bonds and swap markets, and the implications for insurance companies and banks. Issues like systemic risks, funding sources, and the potential impact of illiquid markets are analyzed, highlighting the complexities faced by investment professionals in seeking secure investment avenues.
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BSM: Fixed Income Portfolio ManagementReference Curve Discussion
For the Record • Risk Free Curves Do not Exist! • The Regulator should not prescribed the Curve, because swap and govie are both acceptable strategies. • The regulator should not dictate investment or hedging strategy pursued by investment professionals • Quantify and Measure Basis Risk and apply capital
The search for a “risk free” curve • Definition of risk free • Ability of the issuer or seller to meet obligations • Guarantee that their will be a curve in a meltdown or severe dislocation • Only two options to consider, the government (government bonds) or the banks (swap market) • Europe does not have a euro government issued risk free curve, hence the swap curve was chosen to span all countries in the Euro area.
Considerations, • Most life companies liabilities are funded, so is a government bond purchase. There is a premium to be received for tying up cash. • A swap position only gets funded to the extend of the mark to market change. Swaps by its nature is a geared position. • Governments can raise taxes, banks can’t • Systemic risks can develop if both insurance companies and banks rely on the swap market. • Why is SAM not concerned with Basis Risk (matching premium)?? • Who will fund the government if swap is regarded as risk free and what does it say about bank versus government risk. • Illiquid inflation linked swap market.
