Chapter 20: Actuarial techniques (2)

Question 1

Liability hedging

Answer 1

Where the assets are chosen in such a way as to perform in the exact same way as the liabilities in all states.
Examples: Immunisation and cashflow matching

Question 2

Immunisation

Answer 2

An example of liability hedging, where assets are matched to liabilities by term to reduce interest rate sensitivity (to parallel movements in the yield curve)

Question 3

Cashflow matching using bonds

Answer 3

Investor holds a portfolio of government bonds (in the appropriate currency) until maturity to meet a pre-specified stream of future fixed payments.

Provided future payments do not change in amount and timing, the coupon and principal proceeds from the bond portfolio can be used to meet the obligation to make the payments

Question 4

Problems encountered when cashflow matching with bonds

Answer 4

• Requires bond assets to be held that is equal in PV to the future payments discounted at bond yields (using the full yield curves). Therefore, only a partial hedge is possible if asset cover is less than 100% (e.g. if fund is unfunded)
• the term of the liabilities may extend longer than the term of available government bonds
• may be gaps between the maturities of available bonds - may need to reinvest/disinvest prior to maturity and hence the hedge may be imperfect
• if the process leads to large investment in government bonds, there is credit risk that may not be reflected in the liabilities
• if tax status of government bonds worsens, this means the assets are likely to be insufficient to meet the liability payments
• when valuing at bond rates, there may be some mark to market risk between the valuation of the assets and the valuation of the liabilities

Question 5

What can be used to hedge Sterling RPI-linked payments and US Dollar CPI-linked payments?

Answer 5

UK index-linked Gilts
US Treasury Inflation Protection Securities

Question 6

How can repos be used to construct a liability hedge?

Answer 6

Where there are liquid repo markets on the bonds being used to construct the liability cashflow hedge, repo contracts can be used to release funds. In this way, a leveraged exosure to bonds can be created without investing the full market value.

Question 7

Cashflow matching using bonds and swaps

Answer 7

In markets where liquid and deep interest rate derivatives markets have developed, additional flexibility in hedging fixed payments is available through the use of interest rate swaps.

Inflation-linked payments can be hedged using inflation swaps in combination with an interest rate swap.

Question 8

Synthetic portfolio management

Answer 8

Using derivatives as opposed to direct investment

Question 9

Advantages of using swaps to achieve a liability hedge as opposed to direct investment in bonds

Answer 9

Swaps:

• may have more and longer maturity dates available
• may be more liquid
• may have lower transaction costs
• are geared, which means a full match can be achieved even if funds are limited
• are flexible OTC instruments, which can make it easier to match many liabilities in one swap

Question 10

Disadvantages of using swaps to achieve a liability hedge as opposed to direct investment in bonds

Answer 10

Swaps:

• can require costly legal documentation to be in place with an investment bank
• may require margin payments or other collateral, which could reduce overall liquidity
• are OTC instuments, which could make it harder to close out
• have more counterparty risk - the investment bank may default on payment
• interest rate curves can move differently to government bond interest rate cureves resulting in basis risk

Question 11

Advantages of synthetic portfolio management

Answer 11

• Using RPI swaps, the approach can be extended to match inflation-linked liabilities
• Swap durations can be longer than the duration of available bonds
• Swaps can be more liquid than bonds
• The cost of a swap portfolio can be less than the cost of a bond portfolio
• Full duration hedging can be achieved even if scheme is underfunded
• Swaps are flexible, particularly with regards to the exact term of the swap

Question 12

Disadvantages of synthetic portfolio management

Answer 12

• To enter into a swap agreement ISDA documentation needs to be inplace with one of more market counterparties – expensive & time-consuming to set up
• Swaps will require collateralisation to mitigate credit risk and this may require the movement and investment of collateral on a weekly or daily basis
• Closing out a swap is harder and more complex than selling a bond. In a liquid market closing out a swap may have lower transaction costs than selling a government bond
• Counterparty risk exists with banking counterparties. May result in need for a new swap but at a higher cost (replacement risk) or the hedge lost
• Institutions usually require paying floating (& receive fixed) which means the assets will have to earn a reference rate – not always easy
• Basis risk exists between the swap yield curve and the bond yield curve

Question 13

Other approaches to meeting liability payments

Answer 13

• Holding shorter maturity assets and ‘rolling-over’ contracts.
• May result in higher yield on assets than investing in long-dated assets/entering into long dated swaps
• This higher yield may not lead to a gain as reinvestment terms are uncertain and the ‘roll-over’ process may lead to higher transaction costs in the long run

Question 14

Define the Greeks in the contect of portfolio management

Answer 14

Question 15

PV01 and DV01

Answer 15

PV01 is used as a measure of the sensitivity of the liabilities to chnages in interest rates. It is the change in the PV of the liabilities due to 1 basis point move in interest rates

DV01 measures the same change. DV01 is used when the liabilities are US dollar based

Question 16

Liability Driven Investment (LDI)

Answer 16

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.
LDI is not a strategy or product available in the market but rather an approach to setting an investment strategy.

Question 17

Under an LDI approach it is possible to closely match:

Answer 17

• the interest rate sensitivity (duration) of the liabilities
• the inflation-linkage of the liabilities
• the shape of the liabilities

Question 18

Main risks LDI aims to hedge

Answer 18

• Interest rate risk
• Inflation risk

Products are being developed to manage non-investment risks, e.g. longevity swaps to manage longevity risks

Question 19

LDI and interest rate risk

Answer 19

PV of fixed-rate cashflows payable in the future is linked to the interest rate used to value them. As interest rates risk, the value of the fixed rate liabilities fall and vice versa. The greater the length of time until future cashflows are due, the more sensitive the value is to chnages in interest rates

Can be reduced by investing in instruments that match the duration and value of the fixed rate cashflows payable. Investments used include:

• fixed rate bonds
• interest rate swaps

Question 20

LDI and inflation linked risk

Answer 20

If investor has liabilities linked to inflation, their PV will be sensitive to changes in inflation expectations.

Investor will need to invest in assets with same sensitivity to inflation expectations to reduce any mismatch in performance. Investments used include:

• inflation-linked bonds
• inflation swaps (RPI and LPI swaps)

Question 21

LDI and the shape of liabilities

Answer 21

The shape of the liabilities will depend on when the cashflows are expected to be paid.

Most straightforward way to match liabilities is through holding a portfolio of bonds. Difficult to match longer duration payments due to limited issuance or non-availability of bonds in some countries

• rely on using swaps to hedge both inflation and interest rate risks

Question 22

Dynamic liability benchmarks

Answer 22

Benchmarks given to an investment manager that vary according to the changing nature of the liabilities. Their use reflects an intermediate position between convetional ‘static’ benchmarks and full liability hedging.

• Often used in respect of currencies
• Influences the choice of assets - in particular, the liquidity of the chosen assets