06-20-07 FPAC Minutes - Laserfiche WebLink

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• Maximum maturity and weighted average maturity limits relate directly to an entity's statute and policy constraints,investment objectives and cash flow projections. Although setting maximum maturity constraints may help limit the market risk in a portfolio, it is not generally considered to be the most effective way for managing market risk and understanding the potential price volatility of either an individual security or an entire portfolio. A widely used measure of market risk in the investment industry is modified duration. Durations can be obtained from professional market resources such as Bloomberg. For governments without access to these resources,broker-dealers may send documentation of the durations. Duration is more comprehensive and accurate in measuring market risk than the maturity of a security for two important reasons. First, duration takes into consideration all cash flows(interest and principal payments)of a fixed-income security using their present values. Maturity as a market risk measure only considers the principal payment of a security using its future value. Second,modified duration is a multiplier that measures the approximate percentage change in the value of a security or portfolio given a 1% (100 basis points)move in interest rates. For example,if a security has a modified duration of 1.74 and interest rates rose by 50 basis points,the security would experience approximately a-0.87%change in value. Formula and calculation: (basis points change in yield %change in market value=(-1)*x(modified duration)x 100 -0.87%_(-1)x(1.74)x( 100 ) * multiplied by -1 because of inverse relationship between price and interest rates With this type of price volatility analysis, a government investor can determine more accurately the amount of market risk in a security or portfolio. Weighted average maturity and weighted average duration in a portfolio are calculated using the maturity and duration values of all the securities in a portfolio. Weighted average maturity allows a government to verify compliance with investment constraints since most investment policies and state statutes have maximum weighted average maturity limitations. Weighted average duration is considered industry wide as an acceptable measure of market risk in a portfolio. As such,it can provide the government investor with valuable information for managing the market risk in a portfolio. The Governmental Accounting Standards Board(GASB)in GASB Statement No. 40 requires a disclosure of all risks associated with a government entity's portfolio, including market risk. Weighted average maturity and weighted average duration are two of five accepted methods for disclosing a portfolio's market risk. (A description of the other three is beyond the scope of this Recommended Practice.) In accordance with the GASB fair market value reporting requirements in GASB Statement No. 31, a government entity's portfolio could show unrealized losses or gains for any reporting period. Recommendation. The Government Finance Officers Association(GFOA)makes the following specific recommendations to government investors with respect to managing market risk in their operating portfolios: II/