Ch16: Asset-liability management Flashcards
Principles of investment state that:
- Investments should be chosen that are appropriate for the liabilities (in terms of nature, term, currency and uncertainty) and reflect the risk appetite of the investor
- subject to above, investments should be chosen to maximise returns
Optimal matched position definition
Matched position that satisfies the provider’s required degree of certainty in meeting the liabilities for the least cost, taking into account regulatory requirements and other investment objectives.
Why match? (3)
- To remove risk of not meeting liabilities/objectives
- Forced by regulation
- Regulator imposes additional capital charges on unmatched positions
Why not match? (4)
- Want to maximise returns and matching assets often deliver lower returns
- There are explicit costs associated to matching
- There may not be assets available to match the liability
- We may have lots of free assets
Cashflow components subdivided into four groups:
- Guaranteed in money terms
- Guaranteed in terms of an index
- Discretionary
- Investment-linked
Problems with matching equity index (4)
- Large number of small holdings costly
- Timing of cashflows
- Cost -fees
- Solution: Index-linked derivatives (own problems)
Regulatory restrictions in terms of investment (8)
- Restrictions on the types of assets that a provider can invest in
- Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
- A requirement to match assets and liabilities by currency
- Restrictions on the maximum exposure to a single counterparty
- Custodianship of assets (keep assets safe)
- Requirement to hold a certain proportion of total assets in a particular class for example government stocks
- A requirement to hold a mismatching reserve
- A limit on the extent to which mismatching is allowed at all
Full/Pure matching description
- Structure flow of income and maturity proceeds from the assets so they coincide precisely with the net outgo from the liabilities under all circumstances
- Requires sensitivity of timing and amount of both assets proceeds and the net liability outgo to be known in certainty and be identical with respect to all factors (CUNT)
Liability hedging description
- Assets are chosen in such as way as to perform in a similar way to the liabilities
- Approximate liability hedging:
* In most situations, hedging liabilities with respect to all factors will not be possible, and onlu choose specific factors that affect liability values.
Immunisation definition
- Investment of assets in such a way that the present values of the assets less the present value of the liablities is immune to general small change in the rate of interest.
- Aim is to reduce the risk of failing to meet the liabilities as they fall due, arising from a change in investment conditions
- Conditions for immunisation:
* PV Assets = PV Liabilities
* DMT Assets = DMT Liabilities
* Convexity Assets > Convexity Liabilities
Limitations of classical immunisation theory (8)
- Generally aimed at meeting fixed monetary liabilities, could be done for real liabilities with index linked bonds however may have issues with time-lags associated with indexation
- Possibility of mismatching profits as well as losses are removed apart from a small second-order effect
- Theory relies on small changes in interest rates - fund may not be protected against large changes
- Theory assumes a flat yield curve and requires the same change in interest rates at all terms - In practice ield curve does change shape from time to time
- Portfolio must be rearranged constantly to maintain correct balance of:
* equal discounted mean term
* greater spread of asset proceeds - Theory ignores the dealing costs of a regular rearrangement of assets
- Assets of a suitably long discounted mean term may not exist
- Timing of asset proceeds and liability outgo may not be known
Asset liability model description
- Simultaneously models the assets and liabilities into the future and under different conditions thereby helping to set the best/optimal strategy in order to be most likely to meet objectives
- Tool which helps to decide:
* What assets to invest in
* How much to invest in each asset
* To what degree can we mismatch (and maintain solvency within risk preference)
Asset liability model process
Process:
* Makes assumptions about different variables such as inflation, returns, mortality etc. that affects both assets and liabilities going forward
* Model assets and liabilities together using set of assumptions for particular strategy to see if it meets objectives
* Change strategy to see if there are better strategies
* Run under different assumptions to see how robust it is
* Provide a range of portfolios optimised in risk-return space taking into account the liabilities
* Provides useful info on expected returns and possible range of outcomes
