Chapter 19: Actuarial techniques (1)

Question 1

Asset pricing

Answer 1

Relates to the systematic determination of the value of risky securities such as equities, bonds and derivatives.

Modern asset pricing models derive from the notion that price equals the expected discount payoffs from an asset.

Question 2

Approaches used in asset pricing

Answer 2

• consumption-based models where asset price equals the expected discounted value of asset’s payoff, using investor’s marginal utility to discount the payoff.
• Capital Asset Pricing Model (CAPM)
• Arbitrage Pricing Theory
• Multifactor models
• Option pricing models
• Term structure models

Question 3

Absolute pricing

Answer 3

Prices assets by reference to exposure to fundamental sources of macroeconomic risk, e.g. consumption based and general equilibrium models (CAPM)

• prices obtained are capable of economic interpretation

Question 4

Relative pricing

Answer 4

Considers the value of an asset given the price of some other assets, e.g. Black Scholes option pricing and arbitrage free pricing theory.

• use as little information about the fundamental risk factors as possible and do not ask where the prices of the assets came from

Question 5

General asset pricing formula

Answer 5

Question 6

Dynamic liability benchmark

Answer 6

The benchmark for investing the assets changes as the underlying liabilities change. It is a better reflection of the underlying liabilities than the static benchmark

Question 7

Stages in the ALM exercise

Answer 7

1. Clarify key objectives of the investment and funding policy.
2. Agree suitable assumptions to use in study
3. Collect data to be used to carry out the projections
4. Consider overall nature of liabilities
5. Analyse how scheme might progress in future if different investment strategies were adopted
6. Analyse different asset mixes in more detail
7. Summarise and present the results

Question 8

Asset liability mismatching reserve

Answer 8

Emerging asset and liability position is projected under range of possible conditions to establish extent to which assets and liabilities are mismatched. Supplementary reserves then set up to cover possible level of shortfall identified

Question 9

Absolute matching

Answer 9

Involves structuring the flow of income and maturity proceeds from the assets so that they will coincide precisely with the outgo in respect of the liabilities under all circumstances

Question 10

Deterministic modelling

Answer 10

• Up to modeller to decide nature and extent of scenarios to be tested for purpose of setting the reserve
• Resilience testing: Investigation restricted to current portfolio of assets & liabilities & impact of immediate change in condition is considered, rather than involve projections of the emerging state of the fund
• More dynamic approaches are typically adopted now with modern computer modelling power readily available

Question 11

Stochastic modelling

Answer 11

• Include the use of stochastic techniques, where multiple projections are made to generate many possible future scenarios
• Stochastic element of the projections would apply to the asset portfolio and investment returns to assess exposure to systematic risk
• Given a finite number of projections must be performed, assessment of results often carried out in the form of ruin probability
• Additional reserves set up to cover all but specified proportion of such shortfalls.

Question 12

Resilience testing

Answer 12

Considers the impact of immediate changes in market conditions