Investment - Corobulo's Notes Flashcards
List:
Investment and risk characteristics
SYSTEM T S - security Y - yield S - spread (Capital volitality) T - term E - expenses M - marketability
T - tax
Money market instruments ex.
Bank deposits and short-term equities
Features of money market instruments
Security: Depends on issuer Yield: Real but not high Spread: Low Term: short term Expenses: Minimal Exchange rate: varied Marketability: good Tax: return taxed as income
Bond
Fixed interest or index-linked security that is traded on a bond market.
Features of government bonds
Security: usually very good Return: lower than shares but better than cash = GRY Capital volatility: depends on term Term: greater than a year Expenses: low dealing expenses Exchange rate: varied Marketability: good Tax: income and capital gains may be taxed differently
Yield Curve Theory
- Expectations theory
- Liquidity Preference theory
- Inflation risk premium
- Market Segmentation
Features of corporate bonds
Similar to government bonds, but:
Security: less secure than government
Returns: GRY expected to be higher than for government bonds
Expenses: Higher dealing expenses, but still low
Exchange rate: less varied
Marketability: much less (depends on issue size)
3 types of corporate bonds
- Unsecured loan stock
- Debentures
- Subordinate debt
Unsecured loan stock
Loan not secured on any assets
Debenture
Loan stock assured against the assets of the company
Subordinate debt
Ranks behind other class of debt
3 Assessments for bond security
- Income cover
- Capital cover
- Credit ratings
Features: Preference shares
Dividend: fixed percentage on par value
Cumulative
No final redemption date
No voting rights
Cumulative feature of preference shares
Means that if a dividend is unpaid, the arrears must also be paid off before any payment is made to ordinary shareholders.
4 Yield characteristics
- Nature of return
- Expected return vs. other asset classes
- Correlation of returns with other asset classes
- Currency of returns
Return and risk characteristics of equities
Security: Depends on long term company profitability
Yield: Long term real
Spread: Capital & income values can be volatile
Term: Can be held in perpetuity
Expenses: linked to marketability
Marketability: depends on company size
Return: higher than government bonds over long term
List Asset Classes Risk, Return Characteristics
RETURNS:
- Taxation and expenses (reduction)
- Expected return
- Nature of returns
- Volatility of returns
- Correlation of returns with other asset classes
- Currency of the asset proceeds
ASSET:
- Term of the asset
- Security
- Marketability
- Liquidity
3 Types of Money Market instrument issuers
- Banks
- Companies
- Government (local / central)
4 Money market instruments issued by banks
- Call deposit
- Term deposit
- Notice deposit
- Certificate of deposit
2 Money market instruments issued by governments
- Treasury bill (central government)
- Local Authority bill (local government)
2 Money market instruments issued by companies
- Commercial paper
- Bill of Exchange
Assumption of Gross Redemption Yield
Assumes that you could reinvest the coupons at exactly the same rate,
Ignores expenses and tax.
Uses of money market investments
- Meeting expected liability outgoings
- High degree of uncertainty in liability outgo
- Possible investment opportunities
- Recent Cashflow
- Short-term investment
- Rising interest rate
- Start of a recession
- General economic strategy
For bonds the following holds regarding the yield curve:
Higher Price Lower GRY
Lower Price Higher GRY
Return and Risk Characteristics of Property
Security: void, default, political risk, obsolescence, deterioration, refurbishment costs
Yield: Stepped income stream, long-term real returns
Spread: Long-term volatility of capital values, short-term stability due to infrequent valuations
Expected return: higher than on index-linked government bonds. Between conventional bonds and equities
Marketability: unmarketable - large unit size, indivisibility, uniqueness
Return:
- Running yield between equities and conventional bonds
- High dealing and management costs
- Subjective valuations
2 Elements of an option price
- Intrinsic value
- Time value
Use of derivatives
- Reduce risk (hedging)
- Increase risk/return (speculation)
- Change portfolio characteristics (portfolio management)
When is the time value of a derivative at its highest value
When the option is ‘at the money’ and at inception
Investment strategy
Long-term split of assets for an investor.
Aim of an investment strategy
To maximise investment return subject to an acceptable degree of risk
Factors influencing Investment strategy for Institutions
Existing liabilities:
- Nature
- Currency
- Term
- Level of uncertainty
- Size
- Future accrual
Tax: position of investor and treatment of investments
Statutory, legal or voluntary restrictions,
Expected return, volatility, correlations for various asset classes
Need for diversification
Institution objectives & risk apetite
2 Divisions in the investment strategy setting process
Matching
Actuarial modeling
2 Matching steps in the investment strategy setting process
- Choose assets that closely match liabilities by nature, term, currency
- Useful for keeping A / L stable especially if at a low solvency level
6 Actuarial modelling steps in the investment strategy process
- Define clearly objectives and risk tolerances
- Set up projection models for assets and liabilities
- Asset models should be stochastic
- Choose an initial asset split
- Generate thousands of scenarios with the given asset split, summarise outcomes
- Determine if outcomes meet required objectives, otherwise choose another more appropriate, asset split
3 steps in the main overview of capital project appraisal
- Initial appraisal
- Detailed appraisal
- The investment submission
3 Maiin steps of detailed appraisal
- Define project scope
- Evaluate cashflows
- Assess spread of CFs
2 Steps involved in the assessing the spread of CFs
- Sensitivity analysis
- Scenario testing
A risk matrix sets out
the types of risk per stage of the project
5 Steps in identifying project risks
- High level preliminary analysis
- Brainstorming session with experts and senior personnel
- Desktop analysis of prior similar projects
- Set out all identified risks and interdependencies in a risk register
- Use of a risk matrix
3 Assessments involved in risk analysis
- Frequency and consequences of occurrence
- Correlation between risks, controllability of risks
- Include a NPV per risk in overall NPV
Intangible factors considered with the investment submission before deciding on the project
- Allowance for bias or uncertainty in estimates
- “hung”
- Knowledge not in possession of those who have prepared the submission
- Last-minute developments
- Doubts about feasibility or quality of implementation
- Overall project credibility etc
- Realistic assessment of upside potential
- Whether sponsor criteria is sufficiently met
3 Steps in the Actuarial control cycle
- Define the problem
- Develop the solution
- Monitor experience
2 Effects of the external environment
- Create problems
- Have an impact on solutions
6 Factors from the external environment on the actuarial control cycle
Pestle
- Economic & Commercial
- Social (Client expectation)
- Technology
- Legislative
- Environment
Economic and commercial factors impacting the actuarial control cycle
- Impact of the general economy
- Trends in the industry
- What are your competitors doing
Environmental factors impacting the actuarial control cycle
- Improvements (ex. improvements in mortality)
- Deterioration (ex. weather patterns and flooding risks)
- Impact of what the company is doing on the environment
3 Parts to defining the problem (Act Control Cycle)
- Be precise: What is the underlying issue
- Look at risks and/or issues associated with the problem
- What are the potential solutions
Risks or issues when defining the problem (Act Control Cycle)
- Lack of data
- Are estimates of claim rates reasonable
- Do I know what expenses are likely to be incurred…
