Chapter 19: Actuarial techniques (2)

Question 1

Liability hedging: (2)

Answer 1

1. liability hedging involves selecting assets that perform exactly like the liabilities in all states.
2. Cashflow matching and immunisation are examples of methods of achieving liability matching.

Question 2

Problems encountered when cashflow matching with bonds (6)

Answer 2

1. often the assets do not fully cover the liabilities (eg a scheme may be underfunded)
2. the term of the liabilities may extend longer than the term of available bonds
3. there may be gaps between maturities of available bonds
4. if the process leads to a large investment in government bonds, there is a credit risk.
5. if the tax status of government bonds changes it will have a material impact.
6. when valuing at bond rates, there may be a “mark to market” risk between the valuation of assets and valuation of liabilities.

Question 3

Advantages of using swaps to improve liability matching (6)

Answer 3

1. using RPI swaps, the approach can be extended to match inflation-linked liabilities.
2. swap durations can be longer than the duration of available bonds
3. swaps can be more liquid than bonds
4. the costs of a swap portfolio can be less than that of a bond portfolio
5. full duration hedging can be achieved even if the scheme is underfunded
6. swaps are flexible, particularly with respect to exact term of the swap.

Question 4

Disadvantages of using swaps for liability matching (6)

Answer 4

1. ISDA requirement can be expensive and time-consuming
2. swaps will require collaterisation
3. closing out a swap can be harder than selling a bond
4. counterparty risk exists with the banking counterparties
5. institutions usually require to pay floating (and receive fixed) which means that the assets have to earn LIBOR - this is not always easy
6. basis risk exists between the swap yield curve and the bond yield curve.

Question 5

Liability Driven Investment (LDI): (2)

Answer 5

1. LDI is the terminology used to describe an investment decision where the asset allocation is determined in whole or in part relative to a specific set of liabilities.
2. It is an approach to setting investment strategy.

Question 6

Two main risks LDI aims to hedge: (2)

Answer 6

1. interest rate risk

2. inflation risk

Question 7

Dynamic liability benchmarks

Answer 7

dynamic liability benchmarks are benchmarks given to an investment manager that vary according to the changing nature of the liabilities.

Question 8

Under an LDI approach it is possible to closely match: (3)

Answer 8

1. the interest rate sensitivity (duration) of the liabilities
2. the inflation-linkage of the liabilities
3. the shape of the liabilities

Question 9

Two key risks for most funds, especially pension funds:

Answer 9

1. interest rate risk

2. inflation risk

Question 10

Investments that are used to match duration include: (2)

Answer 10

1. fixed rate bond

2. interest rate swaps

Question 11

Investments used to match inflation liabilities include: (2)

Answer 11

1. inflation-linked bonds

2. inflation swaps (RPI and LPI swaps)