16. Asset Liability management

Question 1

Principles of investment

Answer 1

1. A provider must select investments appropriate to the nature, term, currency and uncertainty of its liabilities and risk appetite.
2. Subject to (1), the investments must also be selected to maximise overall return on the assets, where overall return includes both income and capital.

Question 2

Key points when analysing cash flow scenarios

Answer 2

• POV
• Main cashflows
• Whether:
  > +/-
  > Fixed/real
  > Known/unknown amount
  > Known/unknown timing and term
  > Form of payments

Question 3

Nature of liabilities

Answer 3

1. Guaranteed in money terms
2. Guaranteed in terms of prices/index
3. Discretionary
4. Investment-linked

Question 4

Investment mismatching

Answer 4

• Mismatching assets and liabilities to maximise expected returns
• Depends on level of free assets available

Question 5

Mismatching or resilience reserve

Answer 5

Level of free assets that is kept to reduce the probability of insolvency to an adequate level.

Question 6

Pure investment matching

Answer 6

Structuring the flow of income and maturity proceeds from assets to coincide precisely with liabilities under all circumstances.

Question 7

Liability hedging

Answer 7

Choosing assets such that they perform in a similar way to liabilities

Types:
Full (rarely possible)
Approximate

Question 8

Duration

Answer 8

Weighted-average time to the payments, where the weights are the PV of each payment

Question 9

Assumptions of classical theory of immunisation

Answer 9

1. At any given moment in time, securities can be found that yield a uniform interest rate regardless of the term
2. All funds are invested in fixed interest securities whther they are redeemable/iredeemable at a fixed date

Question 10

Conditions for immunisation

Answer 10

1. PV of assets = PV of liabilities
2. DMT of assets = DMT of liabilities
3. Convexity of assets > Convexity of liabilities

Question 11

Limitations of immunisation

Answer 11

1. Investors may need to match real liabilities.
2. Possibility of mismatching losses and profits is removed except for a small second order effect.
3. Fund may not be protected from large changes in interest rates.
4. Real world yield curve changes shape from time to time and may not be flat.
5. Portfolio must be rearranged to maintain the conditions.
6. Suitable DMT may not be found.
7. Timing of cashflows may be unknown

Question 12

Models

Answer 12

Advantage: encourages investor to formulate explicit objectives

Question 13

Assumptions for the model

Answer 13

Money markets
- Future interest rates

Bonds

• Future inflation
• Future GRY (for fixed interes) or real yields(index-linked)

Equities

• Future dividend growth rates
• Dividend yields

Property

• Future rent increases
• Rental yields

Overseas portfolio:

• Growth rates + yield in foreign country
• Exchange rates
• Extra volatility due to currency fluctuation

Question 14

Optimal matched position

Answer 14

Matched position that saisfy’s provider’s required degree of certainty that L will be met for the least cost.
Taking into acc the regulatory requirements and investment objectives