Chapter 28 Flashcards
3 Non-actuarial techniques (developing an investment strategy)
- Mean-variance optimisation
- Asset allocations based on market capitalisations
- Shadowing strategies of comparable institutions
4 Actuarial techniques (developing an investment strategy)
- Pure/exact matching
- Asset liability models
- Mean-variance with liabilities
- Liability hedging:
- Full hedging
- Approximate hedging
Pure matching
- Asset proceeds coincide precisely with net liability outgo
- Sensitivity of timing & amounts need to be known with certainty
Restrictions of Pure matching
- Except for fixed liabilities (matched with zero coupon bonds) it is rarely possible in practice.
- Suitable assets might not be available / prohibitively expensive.
It is, however, still useful as a benchmark position.
Full hedging / matching
Liabilities ‘behave’ (ito values, returns, CFs) in the same way as assets in terms of all relevant factors affecting assets and liabilities.
In practice it is achievable in limited circumstances.
- Unit price determined by reference to the portfolio
- It can be difficult if the benchmark is determined externally
- Derivatives (especially OTC) are extensively used
Approximate hedging
Hedging with regards to specific factors:
- Nature (fixed/real)
- Term
- Currency
- Immunisation (interest rates)
Immunisation
- Used when pure matching is not possible
- Invest so that “A-L or A/L” is immune to small interest rate changes
Reddingtons classical theory (immunisation)
- PV(liability outgo) = PV(asset-proceeds)
- DMT(liability outgo) = DMT(asset-proceeds)
- Spread arount DMT of asset-proceeds >= Spread arount DMT of liability outgo
Limitations of immunisation
- Aimed at fixed liabilities
- possibility of mismatching profits removed
- theory relies on small changes in interest rates
- theory assumes flat yield curve + same change in interest rate at all terms
- Requires constant rebalancing of portfolio
- Assets with suitably long DMT may not exist
- Unknown timing of asset proceeds / liability outgo.
Asset-liability models
- Measures risk of not meeting investment objectives
- Allows for variation in assets and liabilities simultaneously
- Usually a stochastic model
- Enables comparison of projected asset proceeds / liability outgo under different strategies to find an optimum strategy
- Encourages investors to formulate explicit objectives
Mean-variance portfolio theory with liabilities
- Extends portfolio theory to take account of investor’s liabilities
- Consider size of surplus at end of a single period
- Use mean-variance theory to minimize variance of surplus for a given expected return
In practice, we need to decide how to determine:
- value of the liabilities versus the assets
- variance and covariance of liabilities with assets
3 Components of overall investment risk
- Strategic (or policy) risk
- Structural risk
- Active (or manager) risk
Strategic (or policy risk)
Risk of poor performance of Strategic Benchmark relative to the Fund’s Liabilities
Structural risk
Strategic benchmark ≠ Aggregate of portfolio benchmarks
Active (or manager) risk
Risk that Managers underperform their portfolio benchmarks
