Part 5 / 6 Flashcards
Purchasing power parity (PPP)
two currencies are in equilibrium or at par when a basket of goods (taking into account the exchange rate) is priced the same in both countries.
Total return that investors require on any asset class
Required return = required risk-free real rate of return + expected inflation + risk premium
Expected return of any asset can be analysed as
Expected return = initial income yield + expected capital growth
where capital growth occurs either due to
- income growth
- change in the initial income yield (discount rate)
Dividend discount model
V = D / ( i - g )
Total expected return from equities
d + g
where
- d is the income stream (i.e. the dividend yield)
- g is the expected capital gain (i.e. the expected annual growth in dividends)
Total expected return for property investments
renatal yield + expected growth in rents
Required return for conventional government bonds
required risk-free real yield + expected inflation + inflation risk premium
Required return for corporate bonds
required risk-free real ield + expected inflation + bond risk premium
Required return for equities
required risk-free real yield + expected inflation + equity risk premium
Yield gap
equity gross dividend yield - gross redemption yield on a long-dated benchmark bond
Revers yield gap
Reverse yield gap
= Gross redemption yield - gross dividend yield
= inflation risk premium (IRP) - equity risk premium (ERP) + expected capital gain
= IRP - ERP + expected inflation + expected real dividend growth
Most practical definition of investment risk
Probability of failing to achieve the investor’s objective
Relative performance risk
Risk of underperforming competitors
Who has the ultimate decision on how much risk is acceptable?
- Trustees for a pension fund
- Directors for insurance companies
The risk appetite of an institution will depend on
- The nature of the institution
- the constraints of its governing body and documentation
- legal or statutory controls
How to deal with uncertain liabilities in investment strategy
Hold marketable assets (cash, money market instruments)
Investment benchmark
Matches liabillities by
- nature
- currency
- term
Different sets of liabilities to match simultaneously
- the “realistic” liabilities they need to match on an ongoing basis
- the statutory basis for providing solvency
Two main factor determining preference for income or capital growth
- tax
- cash flow requirements
Factors to be considered before making a tactical asset switch
- expected extra return to be made relative to the additional risk
- constraint on the changes
- expenses of making the switch
- the problems of switching a large portfolio of assets
Difference between strategic and tactical asset allocation
- Strategic investment decisions involve setting the relatively long-term structure of a portfolio (e.g. deciding on the percentage allocation between different asset classes). Tactical decisions involve short-term switching between investments in pursuit of higher returns.Strategic investment decisions involve setting the relatively long-term structure of a portfolio (e.g. deciding on the percentage allocation between different asset classes).
- Tactical decisions involve short-term switching between investments in pursuit of higher returns.
Main factors that influence a long-term investment strategy
- S – Size of the assets (in relation to liabilities and in absolute terms)
- T – Tax (both the treatment of the asset and the investor)
- R – Risk appetite for the institution
- E – Existing asset portfolio
- S – Statutory valuation and solvency
- S – Strategy followed by other funds
- E – Expected long-term return from various asset classes
- D – Need for diversification
- F – Future accrual of liabilities
- O – Objectives of the institution
- R – Restrictions (statutory, legal or voluntary) on how the fund may invest
- T – Term of the existing liabilities
- U - Level of uncertainty of the existing liabilities (both in amount and timing)
- N – Nature of existing liabilities
- E – Currency of existing liabilities
Definitions of investment risk
- Probability of default
- Expected variability of returns
- Risk of underperforming compared to competitors
- Probability of failing to achieve the investor’s objective
The main factors that an individual should consider before investing
- The characteristics of their assets and liabilities (and matching)
- Their cash flow requirements
- Risks arising, in particular the variability of market values
- Returns from different asset classes
- Investment constraints
- Practical considerations
Nature of an individual’s liabilities
mostly real and domestic
Level of risk an individual can take on
- Level of excess assets of the individual
- the uncertainty of future income and outgo
- the risk appetite of the investor
Principles for investments
A provider should select investments that are appropriate to the
- Nature
- Term
- Currency, and
- Uncertainty
Of the liabilities, and
- The provider’s appetite for risk
Net liability outgo
- Benefit payments
- expense outgo
- premium / contribution income
4 types of benefit payments
- Guranateed in money (nominal) terms
- guaranteed in terms of an index
- discretionary
- investment-linked
Measuring active risk
- Historic tracking error (standard deviation of the difference between portfolio return and benchmark return)
- Forward-looking tracking error (estimate of the standard deviation of returns, relative to the benchmark)
- Active money position (Difference between the actual position and the benchmark portfolio)
Risk budgeting process
- Deciding how to allocate the maximum permitted overall risk between
- Total fund active risk
- Strategic risk
- Allocating the total fund active risk across the component portfolios
Liability hedging
assets are chosen in such a way as to perform in the same way as the liabilities
Immunization
Investment of the assets in a way that the present value of the assets less the present value of the liabilities is immune to a general small change in the rate of interest.
Redington immunization theory - conditions
- The present value of the liability outgo and asset proceeds is equal
- The discounted mean term (DMT) of the value of the asset proceeds must equal the discounted mean term of the value of the liability outgo
- The spread about the discounted mean term of the value of the asset proceeds should be greater than the spread of the value of the liability outgo
Mean variance portfolio theory with liabilities
Minimize variance of surplus for a given expected return, where surplus is defined as follows:
Overall investment risk
“sum of”:
- active risk (difference between actual portfolio and benchmark)
- strategic risk (conscious deviation from minimum risk)
- structural risk (mismatch between aggregate of the portfolio benchmarks and the total fund benchmark)
