Constructing an Investment Strategy

Question 1

What is the goal of investing in actuarial applications

Answer 1

Investments which maximise the surplus (PV of assets less PV of liabilities) at each point in time, subject to an acceptable ruin probability
Investment must be appropriate to objective and follow the principle of investment

Question 2

What is the principle of investment

Answer 2

Principle of Investment:
to select investments that are appropriate to the nature, term and currency of the liabilities and the appetite for risk
Subject to (1), maximise the overall (after tax) return on the assets.

Question 3

What can be used (a guide) to help set investment strategy

Answer 3

SYSTEM T to help set an investment strategy.

Question 4

What is the risk free asset

Answer 4

Risk-free asset is not cash but a matching portfolio.

Question 5

Explain concept of a benchmark and how it is used in practice

Answer 5

Benchmark will be the asset distribution of the fund across the principal sectors which is considered, on average over the long term
Must be: Achievable and reproducible
Fund managers can deviate from it to add value to various degrees.
Investment strategy always targets liabilities
The client must be informed correctly of the least risk strategy

Question 6

What is the investment process

Answer 6

Investment objectives - Strategic asset allocation - fund manager structure- fund manager selection - monitoring and evaluating

Question 7

What are the possible structuring of fund managers?

Answer 7

Balance of passive and active, might get some specialist managers for certain investments, oversea investing for example
Might also need to outline the scope for managers to add value

Question 8

What sectors are usually a part of a investment fund

Answer 8

Domestic equities, European equities, other equities, bonds, cash, property.
Would have an investible index in each of these sectors. Key to keep analysing which sectors are adding value

Question 9

What would be suitable benchmark strategy when liability is to pay a fixed pension to a young widow

Answer 9

Government bonds as long as you can get it.
Consoles bonds - perpetuity for government bonds.
Go for longest dated government bonds to avoid mismatch.

Question 10

What is pure matching concept

Answer 10

Complete or pure matching is selecting a portfolio
so income flow will coincide precisely (in timing, amount, and contingency) to the liabilities outgoes.
i.e., the asset proceeds match the liability outgoes under all circumstances.
Pure matching is close to the concept of replicating portfolios,
Every liability there exists a portfolio to match it- not more than one cause otherwise arbitrage
Also beware real amounts must be matched with index linked investment.
In reality you ideally want to take a surplus portfolio

Question 11

What would pure matching approach be for a pension fund

Answer 11

Would estimate the cashflow in respect of all pensions in payment for each future month, assuming a suitable mortality basis. The expected pension cashflow at each future date is then matched by the proceeds of a stripped government bond, or other very low risk bond

Question 12

Explain concept of immunisation

Answer 12

Used when matching is not possible: its a limited form of matching.
Immunisation is the investment of assets in such a manner that the value of the assets will equal the value of the liabilities even on a change in the general level of interest rates, i.e., ensures value of the asset portfolio equals the value of the liability portfolio at all interest rates, PV assets= PV liabilities at ruling interest rate.
Idea is given change in interest rate the relative capital gains offsets the relative reinvestment losses.

Question 13

What are the three conditions for reddingtons immunisation

Answer 13

PV of liabilities=PV of assets at market rate of interest
DMT of assets = DMT of liabilities
Spread of liability proceeds about its mean term is less than that of the asset proceeds.

Question 14

What does Redington’s immunisation assume?

Answer 14

A level yield curve that moves continuously with time
Liability outgoes are known in timing and amount
Asset proceeds are known in timing and amount
Implicitly assuming interest rate movements are small.

Question 15

What are the limitations of Reddington’s immunisation?

Answer 15

In reality interest rates can “gap” and fluctuate.
Liability proceeds or Asset proceeds might not be known with certainty
Suitably long discounted mean term might not exist
Will be immunized against gain as well as loss.
A lot a management required.
Data needed is : future liabilities and DMT
DMT May not exist

Question 16

What are some advanatges of immunisation?

Answer 16

Immunisation overcomes the granularity of fixed interest and index-linked markets for matching.
With a mismatch we will try to minimise this mismatch with investing in the closest matching asset.
The flat yield curve may not be too bad an assumption for longer term liabilities
Immunisation is widely used

Question 17

What is stochastic modelling and what does it involve

Answer 17

Scenario modelling or stochastic modelling, altering the input (investment strategy) to optimise output (surplus, subject to acceptable ruin probability).
Use techniques in time series, historical data sets , the initial conditions
We do simulations multiple times and project the surplus
I can also graph Surplus distribution under different scenarios and different holdings.
Proposed models in actuarial literature are a guide
Stochastic asset model should be Arbitrage-free, multi-asset, multi-currency and capable of handling many (types) assets and liabilities.

Question 18

What is the projected surplus ins stochastic modelling

Answer 18

Projected surplus, S, as the difference between value of assets (A) and liabilities (L) at some future date when return on asset i (Ri) is depends on, say, inflation, GDP, etc, as does the value of the liabilities in the future:

Question 19

List Factors influencing investment strategy Long term

Answer 19

Nature of liabilities
Currency of liabilities
Term of liabilities
Level of uncertainty of liabilities
Future accrual of liabilities
Tax
Statutory, legal or voluntary restrictions
Solvency requirements
Size of the assets
Expected long term return
Existing asset portfolio.
Strategy followed by other funds
Institution’s risk appetite.
Institution’s objectives.
Diversification needs

Question 20

What are the goals of a DB Pension scheme?

Answer 20

To pay pension benefits to members in retirement.
To satisfy requirements of the Pensions Board in the short term
To minimise the cost of the scheme by balancing risk and return

Question 21

How can pension scheme Benefits be funded

Answer 21

Through: Employer & Employee Contributions; or Investment returns

Question 22

Go over the investment stratgey process for funding a DB pension

Answer 22

Define risks and objectives to establish performance criteria
Identify candidate strategies
Finding dynamic in house strategies or derivative solutions
Conduct sensitivity testing
Looking after tax,
Ongoing management:

Question 23

What is the price sensitivity of a bond to change in interest rates

Answer 23

The price sensitivity of the bond to a change in interest rate is approximately the duration of the bond times the change in interest rate

Question 24

Know immunisation derivations

Question 25

Why does Immunisation not work in theory

Answer 25

It assume a flat term structure of interest rates when it is not
It assumes only small changes in interest rates…in reality they gap’.
Implies the model of interest rates moving in parallel level shifts.
Its an arbitrage free model of the interest rate structure…this sort of model is frowned on by financial economists
And dealing and management expenses ignored in the theory

Question 26

Why Even if Immunisation theory worked it might not be applicable in practice

Answer 26

Liability or asset proceeds might not be known with certainty in timing and amount.
Assets of suitably long discounted mean term might not exist

Question 27

Why even if immunisation worked in theory and could be applied in practice we might not want to apply it

Answer 27

It immunises against gain as well as loss.
It requires a lot a management and dealing to maintain the conditions - every time the interest rate changes
Immunisation reduces the risk but there is still a small residual risk. Mostly this risk
relates to estimating future unknowns ex:mortality rates over the next few decades

Question 28

What are the three key things influencing different government vs corporate bonds

Answer 28

Default risk (pro cyclicality)
Marketability
Taxation - sometimes sovereign bonds have taxation advantages not granted to corporate bonds (e.g., exemption from capital gains tax, etc.).

Question 29

How can one reduce the credit risk of investment

Answer 29

Diversified portfolio no one company or sector having a particular concentration.
Ensuring lending is of a high quality - Assess suitable income and capital cover
Amount of debt finance (any prior ranking debt).
The credit rating of the company or bond
Outlook for the company and industry - a good reputation, competent management, good product range?
Risks due to the country, currency, environment, etc.
Moral or ethical issues? - may affect marketability.
Term of investment.
On-going monitoring of holdings/potential holdings can reduce the risk

Question 30

State the principle of investment

Answer 30

(1) to select investments that are appropriate to the nature, term and currency of the liabilities and the appetite for risk
(2) subject to (1), maximise the overall (after tax) return on the assets

Question 31

What are two economic indexes/measures to be aware of that can influence liabilities

Answer 31

Inflation index
Wage inflation ex: Tuition expenses will probably go up in line with wages

Question 32

What is long term expected return on bonds and equities

Answer 32

Long-term expected return on bond is 1-2% real and 4-8% real on equities

Question 33

In stochastic modelling what would be the level of risk and the risk adjusted return

Answer 33

100,000 simulations we would have a prior measure of the surplus S
Risk would be the standard deviation of the empirical realisation of S.
Risk-Adjusted Return – the return above index-linked stock (means of S) divided by
the standard deviation of S