Chapter 36: Valuing liabilities (2) Flashcards
2 Sets of Approaches to valuing assets and liabilities
- Discounted cashflow approach
- Market value approaches
Discounted cashflow approach
long-term discount rate used to value assets and liabilities
Stochastic deflators
Used to calculate values of assets and liabilities on a market-consistent basis by applying deflator to a series of cashflows under a set of realistic scenarios.
2 Definitions of fair value
- The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.
- The amount that the enterprise would have to pay a 3rd party to take over the liability.
3 Different methods of allowing for risk in cashflows
- Build a margin into each assumption
- Apply a contingency loading by increasing the liability value by a certain percentage
- Adjust the rate of return to reflect the risk in the project or liability
3 Different methods of calculating provisions
- Statistical analysis (if many, claims following known pattern)
- Case-by-case estimate (individual assessment of claim records where there are few claims)
- Proportionate approach (base on amount of net premium yet to expire)
Replicating portfolio method
Using a replicating portfolio method involves taking the fair (market) value of the liabilities as the market value of the portfolio of assets that most closely replicates the duration and risk characteristics of the liabilities.
The replicating portfolio can be established by using stochastic optimisation techniques, ie a form of asset / liability modelling.
Mark to market
The inflation rate, discount rate and related assumptions are derived from market information as follows:
- assets are taken at market value
- liabilities are discounted at the yields on investments that match the liabilities - often bonds
- the bond yield may be based on government bonds or corporate bonds - the latter will allow for credit risk
Discounted cashflow method:
Key long-term assumption
future investment return expected.
1 Major criticism of the Discounted cashflow method
It places a different value on the assets from the market value, which introduces an additional element of risk.
3 Market-related approaches
- Asset-based approach
Replicating portfolio methods:
- mark to market
- bond yields plus risk premium
An asset-based discount rate for liabilities can be set where (3)
- Assets are taken at market value. An implied market discount rate is determined for each asset class.
- The liabilities are valued using a discount rate calculated as the weighted average of the individual discount rates based on the proportions invested in each class.
- The discount rate could be determined using the distribution of the investment portfolio or the scheme’s strategic benchmark.
Replicating portfolio method
Involves taking a fair (market) value of the liabilities as the market value of the portfolio of assets that most closely replicated the duration and risk characteristics of the liabilities.
Replicating portfolio method 1:
Mark to market
The inflation rate, discount rate and related assumptions are derived from market information:
- assets are taken at market value
- liabilities are discounted at the yields on investments that match the liabilities - often bonds
- the bond yield will be based on government bonds or corporate bonds - the latter will allow for credit risk
- a better approach would be to use term-standard discount rates that vary over time to reflect the shape of the yield curve
- the market rate of inflation is derived as the difference between the yields on suitable portfolios of fixed-interest and index-linked bonds
Replicating portfolio Method 2: Bond yields plus risk premium
Starts using a discount rate based on bond yields, but then adjusts it to take account of returns expected on other asset classes:
- assets are taken at market value
- liabilities are valued using a discount rate that is found by adjusting bond yields by the addition of either a constant or a variable equity risk premium