Chapter 20: Actuarial techniques (2)

Question 1

Liability hedging

Answer 1

Where the assets are chosen in such a way as to perform in the exact same way as the liabilities in all states.

Question 2

Immunisation

Answer 2

An example of liability hedging, where assets are matched to liabilities by term to reduce interest rate sensitivity (to parallel movements in the yield curve)

Question 3

Cashflow matching using bonds

Answer 3

Investor holds a portfolio of government bonds (in the appropriate currency) until maturity to meet a pre-specified stream of future fixed payments.

Provided future payments do not change in amount and timing, the coupon and principal proceeds from the bond portfolio can be used to meet the obligation to make the payments

Question 4

Problems encountered when cashflow matching with bonds

Answer 4

• Often the assets don’t fully cover the liabilities (if the scheme is underfunded)
• the term of the liabilities may extend longer than the term of available bonds
• may be gaps between the maturities of available bonds - may need to reinvest/disinvest prior to maturity and hence the hedge may be imperfect
• if the process leads to large investment in government bonds, there is credit risk that may not be reflected in the liabilities
• if tax status of government bonds changes, it will have a material impact
• when valuing at bond rates, there may be some mark to market risk between the valuation of the assets and the valuation of the liabilities

Question 5

Synthetic portfolio management

Answer 5

Using derivatives as opposed to direct investment

Question 6

Advantages of using swaps to achieve a liability hedge as opposed to direct investment in bonds

Answer 6

• using RPI swaps, the approach can be extended to match inflation-linked liabilities
• swap durations can be longer than the duration of available bonds
• swaps may be more liquid than bonds
• the cost of a swap portfolio could be less that that of a bond portfolio
• full duration hedging can be achieved even if scheme is underfunded
• swaps are flexible, particularly with respect to exact term of the swap

Question 7

Disadvantages of using swaps to achieve a liability hedge as opposed to direct investment in bonds

Answer 7

• ISDA agreements can be expensive and time consuming to set up
• swaps will require collateralisation
• closing out a swap can be harder than selling a bond
• counterparty risk exists with banking counterparties
• institutions usually require to pay floating and receive fixed which means that the assets have to earn a reference rate - this is not always easy
• basis risk exists between the swap yield curve and the bond yield curve

Question 8

PV01 and DV01

Answer 8

PV01 is used as a measure of the sensitivity of the liabilities to changes in interest rates. It is the change in the PV of the liabilities due to 1 basis point move in interest rates

DV01 measures the same change. DV01 is used when the liabilities are US dollar based

Question 9

Liability Driven Investment (LDI)

Answer 9

The terminology used to describe an investment decision where the asset allocation is determined in whole or in part relative to a specific set of liabilities.
LDI is not a strategy or product available in the market but rather an approach to setting an investment strategy.

Question 10

Under an LDI approach it is possible to closely match:

Answer 10

• the interest rate sensitivity (duration) of the liabilities
• the inflation-linkage of the liabilities
• the shape of the liabilities

Question 11

Main risks LDI aims to hedge

Answer 11

• Interest rate risk
• Inflation risk

Products are being developed to manage non-investment risks, e.g. longevity swaps to manage longevity risks

Question 12

Dynamic liability benchmarks

Answer 12

Benchmarks given to an investment manager that vary according to the changing nature of the liabilities. Their use reflects an intermediate position between convetional ‘static’ benchmarks and full liability hedging.

• Often used in respect of currencies
• Influences the choice of assets - in particular, the liquidity of the chosen assets

Question 13

Matching

Answer 13

Refers to investment in assets which have cashflow profiles which match those of the liabilities in terms of nature (real or nominal), uncertainty, currency, and timing.