2-Financial Markets Page 38 Wednesday, February 4, 2004 1:15 PM
38 The Mathematics of Financial Modeling and Investment Managementpension funds seek to cover the cost of pension obligations at a mini-
mum cost to the plan sponsor. Most investment companies face no
explicit costs for the funds they acquire and must satisfy no specific lia-
bility obligations, the exception being target-term trusts.
A liability is a cash outlay that must be made at a specific time to
satisfy the contractual terms of an obligation. An institutional investor
is concerned with both the amount and timing of liabilities, because its
assets must produce the cash flow to meet any payments it has promised
to make in a timely way. In fact, liabilities are classified according to the
degree of certainty of their amount and timing, as shown in Exhibit 2.1.
This exhibit assumes that the holder of the obligation will not cancel it
prior to any actual or projected payout date.
The descriptions of cash outlays as either known or uncertain are
undoubtedly broad. When we refer to a cash outlay as being uncertain,
we do not mean that it cannot be predicted. There are some liabilities
where the “law of large numbers” makes it easier to predict the timing
and/or amount of cash outlays. This work is typically done by actuaries,
but even actuaries have difficulty predicting natural catastrophes such
as floods and earthquakes.
In our description of each type of risk category, it is important to note
that, just like assets, there are risks associated with liabilities. Some of
these risks are affected by the same factors that affect asset risks.
A Type I liability is one for which both the amount and timing of
the liabilities are known with certainty. An example would be when an
institution knows that it must pay $8 million six months from now.
Banks and thrifts know the amount that they are committed to pay
(principal plus interest) on the maturity date of a fixed-rate certificate of
deposit (CD), assuming that the depositor does not withdraw funds
prior to the maturity date. Type I liabilities, however, are not limited to
depository institutions. A product sold by life insurance companies is a
guaranteed investment contract, popularly referred to as a GIC (dis-
cussed below). The obligation of the life insurance company under this
contract is that, for a sum of money (called a premium), it will guaran-
tee an interest rate up to some specified maturity date.EXHIBIT 2.1 Classification of Liabilities of Institutional InvestorsLiability Type Amount of Outlay Timing of Cash OutlayType I Known Known
Type II Known Uncertain
Type III Uncertain Known
Type IV Uncertain Uncertain