Chapter 36 - Valuation Of Liabilities (2) Flashcards
What are the two broad categories of valuation approaches?
- Passive approach = Valuation methodology is relatively insensitive to market changes and the valuation basis is updated infrequently.
- Active approach = The valuation methodology is sensitive to market conditions and the valuation basis is updated frequently.
Discuss the passive approach to valuing liabilities.
Valuation methodology is insensitive to market conditions and the valuation basis is updated infrequently. Examples - Book value of assets - Net premium valuations of liabilities - DCF with LT assumption Advantages \+ Stable results \+ Less subjective \+ Straightforward to implement Disadvantages - May be more concerned with the ST - Accounting issues
Discuss the advantages and disadvantage of the active approach to valuing liabilities.
+ Less subjectivity
+ Comparable
+ Measure solvency against buy-out standard
+ Understand the share price movement
+ Information about the impact of market conditions on the ability of the company to meet obligations
- Less stable results
- More complex to implement
- Frequency of review
List the methods of liability valuation.
- Discounted cashflow with long-term assumptions
- Asset based discount rate
- Replicating portfolio - mark to market
- Replicating portfolio - bond yield + risk premium
- Stochastic deflators
How does the discounted CF method work.
- A and L are discounted using the LT assumed discount rate
- Actuarial judgement needed for setting discount rate
- Asset values will differ from market values of assets -> increase risk
- Equities = MV.D/i-g
How does the asset-based discount rate work?
- Assets are valued at market value
- Liabilities are valued at a discount rate based on the expected return on assets, as a weighted average of the proportions held in each asset class
- Can be actual A holding or a benchmark
- Market related
- A and L consistent with each other
- Some mismatching risk reduced
Equities - use expected future dividends and current price to estimate the return
Bonds - GRY
Property - subjective
What is the difference between hedgeable and non-hedgeable liabilities.
Hedgeable L: A portfolio can be constructed resulting in the same payout structure, which can be valued. The value of the L is then the cost of the hedge.
Non-hedgeable L: Best estimate + Market Value Margin (MVM)
MVM calculated using cost of capital approach
Best estimate using risk-free rate
What is the replicating portfolio approach to valuing liabilities.
- The value of the Assets are taken as the MV
- The value at which L must be discounted is based on the A that best reflect the duration and risk characteristics of the L
- Stochastic optimisation techniques may be used e.g. A-L modelling
- It is important that ALL assumptions is consistent, i.e. based on the market e.g. inflation rate
- Mark to market
- Bond yields + risk premium
How does the mark to market valuation technique work?
- A=MV
- L = discounted at the return on assets that closely match L
- Usually government or corporate bonds
- Corporate bonds
- Strip out credit element since A does not have default possibility
- Can keep marketability/illiquidity premium if we intend to keep it to maturity
- Tends to be conservative
- Funding level volatile over time if A not invested in bonds
- More complex by using term structure of interest rates to reflect the shape of the yield curve
How does the bond yields plus risk premium liability valuation work?
- A = L
- L valued at bond yield plus a constant/varying premium
- The premium is based on which assets are held -> market info and actuarial judgement
- May not be appropriate since there is no allowance for risk
Explain how stochastic deflators can be used to value liabilities.
- Calculates A and L on market consistent basis
- Deflator = a stochastic discount factor
- Apply deflator to a series of CFs under a set of realistic scenarios
- Real world prob + stochastic deflator OR
Risk neutral prob + risk free discount rate
What is meant by fair value?
- It is the amount for which an asset can be exchanged or a liability settled between willing, knowledgeable parties in an arm’s length transaction.
- It is the amount that the enterprise will have to pay a 3rd party to take over its liabilities.
How would you deal with fair value in financial, non-financial and mismatching risks?
Financial risks
- Replicating portfolios
- Stochastic modelling
Non-financial risks
- Adjust expected cashflows
- Adjust discount rate
Mismatching risk
- Exclude from calculations otherwise it is inconsistent with the principle that the fair value of your liabilities must be calculated independently from assets held.
What are the methods for allowing for risks in cashflows?
- Best estimate plus margins
- Contingency loading
- Discounting cashflows at a risk premium
Discuss the best-estimate + margin approach to allowing for risk in cashflows.
- > Risk margin is added to each assumption depending on the risk involved and the materiality on the final result
- > It can be a simple % loading or it can be modelled stochastically
+ Target area of risk
- Cumulative effect
- Cancel each other out
- Less transparent
- Difficult to explain
