Part 6

Question 1

Risk appetite of an institution depends on

Answer 1

• Nature of the institution
• Constraints of its governing body and documentation
• Legal or statutory controls

Question 2

Main factors influencing a long-term Investment Strategy:

Answer 2

• The nature of the existing liabilities – are they fixed in monetary terms, real or varying in some other way?
• The term of the existing liabilities
• The currency of the existing liabilities
• The level of uncertainty of the existing liabilities – both in amount and timing
• Statutory, legal or voluntary restrictions on how the fund may invest
• Statutory valuations and solvency requirements
• Tax – both the tax treatment of different investments and the tax position of the investor need to be considered
• The size of the assets, both in relation to the liabilities and in absolute terms
• The expected long-term return from various asset classes
• Future accrual of liabilities
• The existing asset portfolio
• The strategy followed by other funds
• The institution’s risk appetite
• The institution’s objectives
• The need for diversification

Question 3

Factors to be considered before making a tactical asset switch

Answer 3

• Level of the free assets
• The expected extra returns to be made relative to the additional risk
• Constraints on the changes that can be made to the portfolio
• Expenses of making the switch
• Problems of switching a large portfolio of assets

Question 4

Factors an individual should consider before making an investment decision

Answer 4

• Nature of assets and liabilities
• Cashflow requirements
• Variability of market values
• Returns earned on various asset classes
• Investment freedom and constraints
• Practical considerations

Question 5

Regulatory framework for investments:

Answer 5

• Restrictions on the type of asset the provider can invest in
• Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
• A requirement to match assets and liabilities by currency
• Restrictions on a maximum exposure to a single counterparty
• Custodianship of assets
• A requirement to hold a certain proportion of total assets in a particular class – for example government stock
• A requirement to hold a mismatching reserve
• A limit on the extent to which mismatching is allowed at all

Question 6

Problems with precise matching

Answer 6

• Uncertainty in timing and amounts of asset inflows and liability outgo
• Assets of long enough term may not exist
• Asset proceeds may exceed liability outgo in the early years

Question 7

Conditions for immunisation

Answer 7

• Value of assets must be equal to value of liabilities
• Discounted mean term of assets must be equal to discounted mean term of liabilities
• Spread about DMT of assets must be greater than the spread about the DMT of the liabilities

Question 8

Limitations of Classical Immunisation theory:

Answer 8

• Immunisation is generally aimed at meeting fixed monetary liabilities. Many investors need to match real liabilities. However the theory can be applied to index-linked liabilities by using index-linked bonds.
• By immunisation, the possibility of mismatching profits as well as losses is removed apart from a small second-order effect.
• The theory relies upon small changes in interest rates. The fund may not be protected against large changes.
• The theory assumes a flat yield curve and requires the same change in interest rates at all times. In practice the yield curve does change shape from time to time.
• In practice, the portfolio must be rearranged constantly to maintain the correct balance of:
o Equal discounted mean term
o Greater spread of asset proceeds
The theory ignores the dealing costs of a daily (or even monthly) rearrangement of assets.
• Assets of a suitably long discounted mean term may not exist.
• The timing of assets proceeds and liability outgo may not be known.