IRM Flashcards

Question

Private Equity Overview

Answer 1

* Info about private companies is hard to obtain, efficient market theory may not apply, so managers with skill and insight may be able to produce superior returns * Private equity investments may enable the investor to exercise a degree of control on the company’s direction, board of directors, etc. * Lack of liquidity may result in lower purchasing prices for a given degree of value, but may make an exit difficult without price concessions * Private companies may be managed more for long-term performance (appropriate for time horizon for pensions); public companies may be under pressure to perform quarter to quarter * Valuations reported can be badly out of date * General partner for private equity investment may charge high fees for the transaction * It may be difficult to establish an expected return assumption for valuation purposes. * Historical research suggests returns may not be significantly higher than public equities with much higher volatility

Answer 2

* Potential for inflation hedge * Diversifier again traditional stocks * Potential for lower volatility * Higher liquidity than other real estate investments since they trade on a stock exchange * May be difficult to quantify risk * More difficult to obtain good, reliable data for real estate

Answer 3

o Provides enhanced diversification due to low correlation with traditional asset classes, allowing it to play a role in risk/return optimization o Offers reliable long-term predictable cash yields to match up with long-term liability o Offers inflation protection, relatively low exposure to economic cycle o Only exposed to interest rate risk indirectly o Long operational lives and high operation margins. o Long investment horizon, return not driven by exit strategy

Answer 4

o Patronage/demand risk: certain assets (e.g. transportation) have patronage/demand that varies with the business cycle; increases correlation with other assets types. o Regulatory risk: Political and business climate may impact regulation/growth depending if regulatory structure is governmental o Contractual/credit risk: long term contracts expose counterparties to risk o Operational/construction risk: from large, complicated infrastructure projects o Financial/inflation risk: Leverage involved in financing exposes investors to the costs of debt and refinancing risk o Fund manager risk: Manager must have in-depth sector knowledge

Answer 5

* Illiquidity premium provides opportunity for enhanced return relative to equivalent liquid asset * Illiquid alternatives are attractive for a pension plan that can tolerate long investment horizons and the restrictions on withdrawals * Avoids the inherent discount with tradeable nature of public assets * Aligned interest of owners and managers help limit the waste of free cash flow * Asymmetric information exists allowing some investors to achieve returns substantially different from public market indices

Answer 6

o Interest risk: risk that yield of bond will change due to changes in risk-free bond o Duration risk: how much bond price will change as interest rate changes; active management may be used in fixed income portfolios to match duration to pension liabilities o Yield curve risk: risk that value will change due to change in shape of yield curve  Parallel upward shift in yield curve results in a decrease in return  Parallel downward shift in yield curve results in an increase in return o Inflation risk: some fixed income pays fixed payments, does not consider inflation o Reinvestment risk: if interest rate falls, bond may be reinvested at lower rate o Prepayment risk: risk that the borrower of a mortgaged-backed security can prepay their mortgages at face value and replace them with other mortgages at a lower rate o Liquidity risk: inability to sell bond in future due to lack of trading or high bid-ask spread o Volatility risk: value impacted by how much interest rates move in either direction o Default risk: the possibility that the debtor will not be able to make coupon payments; built into fixed income yield o Credit risk: risk that the issuer is unwilling or unable to pay the agreed upon cash flows o Currency risk: risk by investing in fixed income that is not in the investor’s base currency o Sector risk: risk due to change in spread between sector and baseline yield curve o Security – specific risk: risk due to the specific security that cannot be explained by any other fixed income risk factors.

Answer 7

o High-Income Strategies: effective diversifiers since higher returns than traditional bonds o Global Bond Strategies: can lessen impact of a sharp rise in US interest rates o Low-Duration Strategies: Help reduce interest rates sensitivity and volatility o Fixed-Income Diversifiers: Returns driven primarily by manager skill rather than broad market exposure (non-traditional bonds, market-neutral strategies, etc.)

Answer 8

o Duration timing strategy:  Market timing strategy where portfolio manager positions the portfolio to have a longer or shorter average duration than the benchmark. o Yield curve positioning strategy:  Manager overweights contribution to duration of one or more part of yield curve, offsets long positions with underweights of other parts of yield curve.  Strategy is usually run market neutral (i.e. net duration of zero) o Sector allocation strategy:  Manager overweights and underweights position in the various fixed income sectors relative to the chosen benchmark.  Weighting can be based on relative spread advantage to other sectors and/or an expectation of future spread tightening or expanding. o Security selection strategy:  Manager selects individual securities within each sector in which portfolio is invested; allows managers to diversify across many different active decisions o Country allocation strategy:  Manager takes active long and short positions in bonds priced off the yield curve of one country vs. bonds priced off of the yield curve of another country  Generally run to market neutral with respect to global interest rates o Currency allocation strategy:  Use currency forward contracts that explicitly expose the portfolio to one currency vs. another

Answer 9

* Returns for a low volatility equity strategy should be expected to be lower than general equities, as a tradeoff for lower equity risk * Lower equity risk may free the firm’s capacity to use more of its ‘risk budget’ elsewhere in the portfolio, for potentially greater returns

Answer 10

o Investing 100% in bonds increases interest rate protection, which can reduce both contribution volatility and funded status volatility o By gaining fixed income exposure through the pension plan, shareholders can experience a tax arbitrage opportunity, which may drive the attractiveness of the stock o Bonds have similar characteristics to pension liabilities, reducing risk through improving the liability match o Government bonds have low default risk

Answer 11

o Scarcity of long-term Treasuries, which contributes to lower yields for Treasuries relative to other bonds o Requires the plan to forgo the potential for growth assets to help reduce the plan deficit o Bonds may introduce a large amount of credit spread and yield curve risk o Bonds do not help with hedging the economic risk in the liability, such as future accruals o A 100% bond portfolio may not be appropriately diversified o Bonds typically do not protect against inflation o Default Risk - PBGC put option can argue for investing in equities

Answer 12

o Pay the lowest taxes for the public services that taxpayers require (short-term thinking) o Expect state and local governments to hire and retain the best public sector employees o Tax money should be used wisely, i.e. public pension plan surplus should be minimized o Reduce tax burden by keeping assets in the plan instead of paying out for benefits enhancement or other purposes o Cost for public pension plan is predictable and does not impinge on other public services

Answer 13

o Re-election is often the primary goal o Provide rich benefits to public servants and the best public services at the lowest cost o Elected officials want to raid pension assets to use for other projects

Answer 14

Desire robust, adequate retirement benefits, many are not covered by social security o Do not want negative surprises in benefit levels as they approach retirement o Want benefit increases when there is a funding surplus o Want to make the least contributions for the greatest pension benefits o Maximize overall compensation package

Answer 15

o Balance competing needs for the funds that are required to put in the pension plan o Costs are predictable o Pensions have a substantial role in recruiting new employees

Answer 16

* Public plans are not governed by ERISA: not subject to minimum funding rules * In case of default in contribution payments, not protected by PBGC * Contributions determined by measuring liabilities deterministically * Many plans raise benefits when funding improves but cannot cut benefits when funding deteriorates * System can be "gamed" by assuming a higher discount rate * Investment policy can be changed to increase equity exposure to justify higher expected rate of return to calculate contributions * Most public systems consider the required contribution amount as the accounting cost * Funding cost is thus important for budgetary purposes * Elected administration prefers funding costs are as low as possible so that more of the budget is available to finance the administration's goals * Assets tend to be kept at "book" value or smoothed market value * Discount rate used to measure liabilities usually set artificially, such as the long-term expected return on the portfolio * Surplus assets tend to be used to increase the benefits, which in turn leads to increased costs and long run underfunding. * The burden of appropriate funding seems to fall mainly on the shoulders of the plan actuary who is usually a hired consultant and not in a very strong position. * Insufficient funding by legislative bodies, explained by slippery slope of skipping contributions * Public pension plans often provide excessive benefit levels in relation to the risk capacity of the plan sponsor to fund them, because of challenge of managing plan surplus in relation to ongoing investment risk

Answer 17

• Asset/liability matching: o Asset/liability matching is investing in assets that move in tandem with liabilities o Asymmetry in payoff pattern: shortfalls lead to higher tax burden while surpluses lead to increase in benefits o Liabilities that move in tandem with assets will reduce eventuality of funding shortfall • Amount of equity exposure: o Plan design of most public pension plans: final average pay, cost of living adjustments, early retirement subsidies; creates volatility in relationship between bonds and liabilities o Using optimal equity exposure will improve the funded status over time

Answer 18

 Higher expected return for equities reduces pension expense  Equities conceal volatility and risks, may make financial statements look better

Answer 19

 Pension benefits are mispriced in negotiations and compensation decisions  Risks are borne by individuals not institutions  Shareholder would prefer investment in bonds due to tax arbitrage  Valuing plan using equities does not reflect the real market value  Shareholder unlikely to recover surplus, often belongs to the plan participants

Answer 20

 Prefer lower taxes now, can move to avoid troubled pension fund

Answer 21

 Equity investments invite underpricing of pension plans  Intergenerational risk means lower contributions now pass higher taxes to future generation  Employees and not taxpayers usually have claim on surplus  Higher government borrowing costs for entities who invest in equities

Answer 22

• Time horizon: can take a long time to uncover poor management decisions o Once discovered, it may be too late to utilize cost effective risk management strategies • Lack of control structure: no single person responsible for/has authority to make plan decisions o Plans can be mismanaged in the short-term with long-term consequences • Lack of effective regulatory standard: no single regulator to compel certain disclosures o GASB standards exist for accounting, but more leeway in how information is disclosed than the private sector o Discount rate can be based on the EROA which can understate the liability o More susceptible to political pressures, increasing complexity and long-term costs • Economic and demographic cycles: impact the need for cash contributions. • Pension liabilities cannot be exactly hedged in the capital markets: t any point in time there will be a perceived shortfall or surplus in the fund

Answer 23

• Asset Assumptions o Returns: assumed returns by asset class o Volatility: variability of asset class returns o Correlation: connection between returns of different asset classes • Liability Assumptions o Valuation Assumptions: initial liability calculation basis o Assumption Changes: future liability calculation basis o Sensitivity: liability behavior to assumption changes o Experience Assumptions: new entrants, retirements, terminations, etc. • Financial Assumptions o Contribution Policy: level on timing of future contributions o Accounting Policy: determination of pension expense o Investment Policy: asset allocation and rebalancing strategy

Answer 24

* Contributions: funding requirements as dollars or cumulative average * Pension Expense: as dollars or cumulative average, balance sheet measures * Funded Status: as percentage or absolute dollar amount * Benefit Payments: expected streams of cash flows, payroll cashflows

Answer 25

* An LDI strategy will reduce volatility of funded status of a plan by considering the characteristics of the liabilities when choosing assets * When done correctly, plan’s assets and liabilities

Answer 26

o Guaranteed investment that exactly matches the economic basis of the liabilities o Eliminates basis risk that exists between traditional LDI and discount rate used to calculate plan liabilities

Answer 27

* A glide path balances strategic policy with tactical implementation * Risk management incorporated into the investment policy * De-risking occurs incrementally based on pre-established triggers, effectively mitigating the risk of mistiming or second-guessing a decision * Avoids inaction, changes investment strategies based pre-defined triggers * De-risking decisions are pre-determined, removing emotions from decision making

Answer 28

• Data Availability: funded status data must be available in a timely matter (monthly or quarterly) o Can estimate liability using yield curve / cashflows, asset data usually available • Change Date: reallocating at end of month can be easier for management and reporting cycle • Contributions: integrating contributions with rebalancing can reduce costs o Contributions improve the funded status of the plan, which may lead to a glide path trigger and, thus, a different target asset mix. o If tactful, contributions can be invested in such a way as to minimize trading costs. • Rebalancing Policy: policy must accommodate dynamic approach and allowances for illiquid assets • Trading: Funded status ranges can cause excess trading costs if too small and difficulty with large trades if too large o The policy should articulate how trading will be managed as funded status triggers are hit and the asset allocation is revised o Trigger distance • Clear determination of end state: should reflect plan sponsor’s strategic objectives o Associated with risk profile that best supports plan’s desired long-term objectives • Appropriate trigger points: trigger points that will drive de-risking, consistent with end state • Governance: Predetermined strategy allows assets to be reallocated in a timely manner with approvals already granted. o Outlining and documenting a formal process governing the way in which the glide path will be executed o More complex than a static asset allocation, requires increased monitoring and introduces additional procedures in the plan’s operation. o Process should allow for implementation without additional layers of approval • Reporting: procedures must be well-defined (assets, liabilities, funded status). • Review Policy: policy should be reviewed regularly to determine if still appropriate

Answer 29

o Still accruing benefits, investing in variable amounts of stock may be a better hedge for changes in pay or industry related variables than less risky bonds o Risk management and capital allocation decisions; optimal asset allocation decision may involve investing in variable amounts of stock depending on the risk of the plan o If a plan is not 100% funded, cash flows cannot be matched exactly. o Higher equities for lower funded statuses give assets a chance of meeting liability needs o Helps avoid trapped capital: move assets out of riskier assets automatically o Sets rules in advance leaving less room for interpretation by the trust’s governing board

Answer 30

o Basing the glide path on accounting funded status instead of plan termination funded status could leave plan over/under exposed to riskier assets if they choose to terminate o Transaction costs associated with frequent asset rebalancing o Higher volatility portfolios at lower funded statuses leave possibility of asset losses o Data availability: might be difficult to calculate asset values frequently for illiquid classes; similarly may be difficult to get frequent liability values (more than annual) o Potentially requires a more complex governance and monitoring process

Answer 31

o Sensitivity to changes in interest rates is main cause of variability in pension liabilities o To hedge interest-rate sensitivity, must make duration of assets similar to liabilities o Effective duration perhaps the most used measure of interest rate risk exposure of an interest rate contingent claim o Key rate duration matching: more complex to implement

Answer 32

``` o Duration-based models of risk assume parallel shifts in the yield curve (unlikely) o Plans continue to maintain low hedge ratios due to concern over rising interest rates that would “lock-in” a high cost for the hedging of this risk o Effective duration often inadequate in measuring a security’s interest rate risk exposure o Portfolios can have same effective duration but different interest rate risk exposure o Immunization (matching duration all along curve) is required for nonparallel shifts o It does not consider the convexity o Key rate durations can identify price sensitivity of bond to each segment of yield curve o Key rate durations can provide valuable insight into option-embedded bond behavior o Key rate durations can be used to better control interest rate risk exposure ```

Answer 33

• Adding a sinking fund to a bond o Reduces effective duration of the bond o Makes the bond more sensitive to shorter-term key rates o Significantly reduces the long-term key rate durations • Adding a European put option to a bond o Large negative effective duration o Large positive key rate duration at expiration, large negative key rate durations beyond • 10% callable bond o Effective duration is lower than 10% noncallable bond due to call feature o Callable bond more sensitive to shorter-term key rate changes

Answer 34

• Periodic exchange of cash flows: one party pays cashflows based on a fixed interest rate while the counterparty pays a floating interest rate • Creditworthiness of counterparties is very important • For most swaps, the floating rate is tied to an index • Duration of swap is difference between duration of the fixed-rate bond and floating-rate bond • Typically investment bank pays a fixed rate of interest and the pension fund pays a floating rate • Interest rate sensitivity of pension fund more closely aligned with rate sensitivity of liabilities • Interest rate swaps can be used to lengthen duration without committing much capital • Considerations regarding the interest swap overlay strategy o Achieve better asset/liability duration match, effectively minimize interest rate risk o Asset portfolio allocations may remain unchanged, while overlaying swap can increase the duration of the portfolio (maximize expected return of portfolio)

Answer 35

• Net settlement payments on a receive-fixed interest rate swap are the same as being long a fixed-rate bond and short an offsetting floating-rate bond • Duration of the swap is the difference between the (relatively high) duration of the fixed-rate bond and the (very low) duration of the floating-rate bond • For the fixed-rate receiver (and floating-rate payer), the interest rate swap has positive duration • The initial market value of the swap is zero. o If interest rates fall, the value of the swap becomes positive

Answer 36

Requires up-front premium o At exercise date, if the swap rate < strike rate, option is "in the money,” plan can take delivery of the swap o The swap gain should offset the corresponding increase in pension liability

Answer 37

plan buys a receiver swaption and sells a payer swaption with higher strike rate. This reduces or eliminates the up-front expense, making it (potentially) a “zero cost” collar o If swap rate is between the two strike rates, both swaptions expire “out of the money” o If the swap rate < strike rate for the purchased receiver swaption, gain on the swaption is offset by increase in pension liability. o If the swap rate > strike rate for the sold payer swaption, loss on the swaption is offset by decrease in pension liability

Answer 38

• Cost – a swap can be entered without the upfront cost of purchasing a swaption. o Swaption cost could be reduced (or eliminated) by entering into a swaption collar • Timing – swaptions have expiration date, duration gap will need to be reassessed • Complexity / Monitoring – Swaptions need continual monitoring o In practice, many plan managers choose a partial swap hedge rather than a full hedge o Risk: assets and liabilities will not change exactly as expected based on duration alone

Answer 39

• Investors’ cumulative net cash flows form a “J-Curve”, first slope down into negative (outflow) territory, then rise back to neutral, and if successful, becoming strongly positive • Investors make an upfront commitment to invest dollar amount into limited partnership • Commitment is then “called down” incrementally by the fund manager over the investment period to fund investments in portfolio companies and to pay fees and expenses o Investment period over a term of 3-6 years, harvesting investments additional 3-6 years • Invested capital is returned in the form of distributions generated by company sales or IPOs

Answer 40

* Pension cash flows differ from bonds because they are contingent upon future events that do not affect ordinary bonds (which are contractually set). * The term of a pension plan is longer than a bond even without accounting for future participants * No balloon payment date for a pension plan when significant portion of liability comes due * Liabilities behave differently from bonds in certain economic conditions such as rapid inflation * Pensions do not trade in financial markets, should not be valued like traded securities

Answer 41

o Obtain projected benefit cash flows from plan actuary or plan trustees.  Will need to determine the appropriate benefit payment profile (ABO vs. PBO) o Calculate the present value; need to determine the discount rate to be used  Full yield curve approach based on either corporate or government yield curves  Better measurement of each cash flow and its contribution to volatility

Answer 42

o Investable: option is available to forgo active management and simply hold benchmark  Pension liability considered stream of cash flows held short (bond portfolio) o Unambiguous: clearly defined names and weights of securities comprising benchmark  Pension liability calculation based on census as of particular date o Appropriate: benchmark is consistent with the manager’s investment style biases  Actuaries can analyze liability cash flows and sensitivities of pension plan o Measurable: Can calculate the return on the benchmark on a reasonably frequent basis  Can measure present value of liabilities on each valuation date o Reflective of current investment options o Specified in advance: prior to start of evaluation period, known to all interested parties o Owned: investment manager accept responsibility for performance of benchmark

Answer 43

o Serves as a scorecard for plan sponsors to measure plan performance.  In an LDI framework, appropriate benchmark is the plan liabilities  Aligning the plan assets to make certain of benefits to be paid from the plan requires measuring their performance relative to the liabilities o Benchmark can be used to compare to plan results utilizing standard analysis  Goal of LDI is to minimize tracking error by reducing unrewarded risks • Tracking error (measures funded status volatility): Indicates how closely returns of the assets are tracking liability returns.  Can replicate the liability benchmark using index-provided swap securities. • Automated daily values available from these providers

Answer 44

o May not be consistent with the fund manager’s style o The median can’t be specified in advance, which also means it is not investable o It is subject to survivorship bias. o Only quality of a good benchmark that it possesses is that it is measurable.

Answer 45

o Can be specified in advance, measure able, investable, unambiguous o Not subject to survivorship bias

Answer 46

• Measure the portfolio’s beta relative to benchmark o Beta is close to 1 if no bias • Calculate the active return (portfolio – benchmark); calculate the return attributable to style (benchmark – market); calculate the correlation of active return and return attributable to style o Correlation is close to 0 if no bias • Calculate the return attributable to style (benchmark – market); calculate the portfolio’s excess return over market (portfolio – market); calculate the correlation between the two o Statistically significant positive correlation if no bias

Answer 47

* Tracking error of the portfolio relative to appropriate benchmark should be less than the tracking error of the portfolio relative to a market index * A benchmark’s risk characteristics should be similar to that of the portfolio * Should have high coverage, proportion of portfolio’s market value contained in benchmark * Benchmark turnover (the proportion of the benchmark’s market value allocated to purchases during a period rebalancing of the benchmark) should not be excessively high * Consist of largely positive active positions (portfolio’s allocation to a security minus the corresponding allocation of the same security in the benchmark)

Answer 48

• MWR represents average growth rate of all money invested in an account, TWR represents growth of a single unit of money invested in the account • MWR is sensitive to size and timing of external cash flows. TWR is not. • MWR and TWR will be the same if there are no cash flows during the period • Investment manager has little or no control over size/timing of external cash flows • Benchmark returns do not reflect cash flows: TWR and MWR are the same • Linked-Internal Return is an approximation of TWR by doing MWR over some reasonable frequency of time periods o Higher the frequency, closer to TWR

Answer 49

• Interest rate management effect: measures how well manager predicts interest rate changes. o Each security in the portfolio is priced as if it is a default-free security. o Contribution calculated by subtracting the return of entire Treasury universe from the aggregate return of these repriced securities • Sector / quality effect: measures the manager’s ability to select the “right” issuing sector and quality group. o Can be estimated by repricing each security in the portfolio using the average yield premium in its respective category. • Security selection effect: measures how the return of a specific security within its sector relates to the average performance of the sector o Total return of a security minus all other components • Trading activity: measures the effect of sales and purchases of bonds over a given period o Calculated as total portfolio return minus all the other components

Answer 50

o Take volatility of returns into account when comparing portfolio returns o Allow comparison of different managers on a level playing field o Quantify the expected return needed to take on increased risk o Demonstrate that a fund manager’s results are based on skilled choices rather than picking a risky but lucky investment

Answer 51

o Some measures depend on the validity of CAPM o May rely on the use of surrogates for the true market portfolio o Stability: If the measures were calculated over different time periods, the results and potential conclusions might be different even for a stable risk/return relationship o Only estimates of the true parameters of the actual risk/return relationships

Answer 52

o Determine whether returns achieved are sufficient to compensate for level of risk taken o Determine whether manager generates consistent excess risk-adjusted performance compared to benchmark / peer group o Basis for identifying managers who generate high-quality excess risk-adjusted returns

Answer 53

o Can be performed on a micro, macro and factor basis o Relatively easy to calculate and split out returns to different securities and sectors o Allows returns to be separated out into the same risk buckets used for budgeting o Test whether a manager has generated excess returns purely due to their risk factors o Can only compare managers that use the same risk/return factors to select investments

Answer 54

o Can be used at the individual security, sector, country or fund level o Focuses on active returns and active risks by using tracking error which reflects only risk taken to achieve excess returns o Can be used to measure relative performance against a benchmark or peer group o Test whether a manager has generated sufficient returns to compensate for risk taken o Relies on benchmark data that may not be readily available o Calculated using actual realized results which may not produce the same relative ranking when using estimates to forecast the future o Cannot distinguish between different manager styles

Answer 55

• Sector Choice or Pure Sector Allocation: assumes that within each sector the fund manager held the same securities as the benchmark and in the same proportion o Relative impact of sector-weight decisions • Interaction or Allocation/Selection Interaction: captures interaction between sector-weights and within-sector equity-weights relative to the benchmark. o Joint effect of a portfolio manager’s sector and security weighting decisions • Security Within-Sector or Within Sector Selection: assumes that the manager weights every sector in the portfolio the same as its weight in the benchmark. o Measures value added by particular security selections of the manager within a sector • Sum of all 3 components = value added return, or return of portfolio in excess of benchmark o Can be used to measure a manager’s effectiveness.

Answer 56

* A pension plan is a vehicle used by shareholders to compensate employees for their services * Analyses that focus on pension alone are unable to reflect the shareholder value perspective * Pension plans cannot be managed on a time horizon that differs from that of the shareholder * Shareholders own the assets and owe the liabilities of the plans they sponsor * Asset and liability risk of the plan passes through to the shareholders. * Debt/equity mix of pension plan assets does not affect shareholder value on a first order basis, but does matter with respect to taxes, agency costs, and surplus ownership * Shareholders can adjust their personal portfolios to reflect the pension plan’s holdings

Answer 57

* Investors act rationally to maximize the expected utility of wealth * Investors have homogenous expectations and use the same input list * There are many investors, each with an endowment of wealth which is small compared to the total endowment of all investors * All investors plan for one identical holding period

Answer 58

``` o Calculate expected returns, standard deviations, correlation for included asset class o Determine the efficient frontier methodology to be implemented, options include:  Quadratic programming (Mean-variance frontier, Single-period frontier)  Non-linear programming (Mean-variance, multiple period, downside risk) o Determine the model constraints amongst the following categories:  Liquidity: illiquid assets classes maybe restricted  Fiduciary issues: some assets classes may have limitations  Accuracy of estimates: uncertainty around assumptions for expected return and other statistics for an asset class  Investment policy: allocations restricted by external or internal requirements ```

Answer 59

o Optimize portfolio returns relative to plan liabilities | o Define risk/reward statistics in term of the funding deficit

Answer 60

o Optimize the risk/return at the end of a multi-year period | o Allows for serial correlation and other relationships between years to be modeled

Answer 61

o Require specification of target funded ratio, risk is calculated relative to that target o Changes in the target will change the frontier o Poorly chosen target may result in a one portfolio solution or overly aggressive/conservative portfolios

Answer 62

• The ABO valued in a true market basis is a preferred measured to the PBO by financial economists to measure the economic obligation o PBO usually needs to be adjusted to reflect a lower discount rate and an adequate mortality and improvement assumptions to be closer to the true economic obligation o PBO may not reflect the value of embedded options available to participants when interest rates change, such as adjustable cash balance crediting rate, or interest rate used for lump-sum options. o PBO may also not reflect the value of contingent liabilities based on the funded status of the pension plan • Pension Liability = PBO + adjustment for market rates + PV of future expenses • Sponsor may consider adjusting the liability to exclude liability related to future salary increases

Answer 63

* Market beta takes into account the holistic, not the accounting, balance sheet * WACC under holistic balance sheet approach < accounting balance sheet (WACC is overstated) * May cause management to abandon investment projects justified under a lower WACC

Answer 64

* Address shortfall risk by forcing plans sponsors to contribute a minimum amount to the pension plan, ensuring a certain “safety” of benefits if employer cannot meet future obligations * Solvency rules ensure plans are funded on the basis on the economic value of the benefits in case the plan is terminated

Answer 65

* Address risk that financial statements do not adequately reflect plan assets, obligation or both, misleading investors and/or creditors in their evaluation of the plan sponsor’s financial situation * Standard rules for presenting pension obligation and assets, mostly mark-to-market approaches to assets and liabilities, focus is increasingly on current financial situation * Require certain disclosures that enhances transparency for pension plan accounting obligation

Answer 66

* Exacerbate business cycle swings to the point of harming the financial health of pension plans, the companies that fund them * Requiring additional contributions in economic downturns is damagingly procyclical: reduces business investment and further depresses the economic cycle * Permitting contribution holidays in economic upturn is damagingly pro-cyclical: frees up capital to drive economic cycle, at expense of strengthening pension plan funding when easiest to do so * Fair value accounting/market value accounting and risk-based regulations encourage the fire sale of assets in market downturns to meet risk-based funding level requirements

Answer 67

• Avoid excessive reliance on current market values for purposes of setting contributions o Mark-to-market values are too volatile for use in determining contributions. o Consider smoothing of spot rates for liabilities to dampen the effect • Regulators could encourage sponsors to dampen volatility of market prices when determining contributions • Funding regulations should encourage increased contribution to reduce deficit and appropriate build-up of surplus when plan sponsor finances are strong • Set minimum funding levels or targets consistent with goal of benefit security • Allow appropriate overfunding in economically good times, via more flexible tax ceilings. • Allow maximum contribution or funding ceilings to be smoothed over multi-year period • Limit contribution holidays and plan sponsor access to surplus • Encourage stability of long-term contribution patterns through appropriate actuarial methods • The actuarial method should be transparent, with smooth and sensible contribution patterns • Recovery periods to eliminate funding deficits should reflect overall volatility of funding levels

Answer 68

• Regulators should consider nature of risks and guarantees offered under different plan designs o Market risk, biometric risk (especially longevity risk for annuities), operational risk • Regulators should consider extent to which plan benefits are conditional and can be adjusted • Regulators should consider extent to which contributions may be raised to cover funding gap • Regulators should consider any guarantees from sponsoring employer and any insolvency guarantee arrangements

Answer 69

* The Duty of Loyalty * The Duty of Care * The Duty to Diversify Plan Assets * The Duty of Impartiality * The Duty to Delegate * The Duty to Follow Statutory Constraints (Avoid Prohibited Transactions) * The Duty to Make the Property Productive * Duties Regarding Co-Trustees * The Duty to Act in Accordance with the Trust Agreement

Answer 70

* Each trustee should be aware of investments of the other, can form balanced fund * Trustee under a duty to take whatever actions are reasonably necessary and appropriate to prevent co-trustees from breaching their duties, and cause the co-trustee to compensate fund for loss if breach does occur

Answer 71

• Fiduciary standard for the administrator to exercise care, diligence, and skill of person of ordinary prudence • With respect to investment policy documentation: o SIPP should document the authorized use and overall objective of derivatives o Risk Management Practices should document derivative uses, strategies, risk tolerances  Value derivatives regularly  Establish sufficient collateral requirement for each derivative  Limits on derivatives, based on their intended use, strategies, and risk o Risk monitoring should include:  Controlling and monitoring the plan’s exposure to each source of market risk  Monitoring counterparty credit risk and exposure limits • PPR addresses risk of holding risky assets within the pension plan. o Ensures that there is both adequacy of assets and an appropriate level of risk. o Does not focus unduly on risk and liquidity of individual assets, but accounts for at the portfolio level, default risk and price volatility can be reduced by diversification • PPR addresses risk of plan members holding risky assets within their DC account o Requiring plan sponsors offer a diverse range of investment options o Default option which should be designed to so that member’s investments reflect their risk profile and use diversification

Answer 72

• The logic of QAR or ‘prudent investment’ rules is that prudence is equaled to safety • QAR: specific regulations, limiting holding of particular classes of assets deemed ‘risky’. o Involves limits on holdings of assets with relatively volatile nominal returns, low liquidity, or high credit risk, such as equities, real estate, foreign assets. • Under the prudent person rule (PPR), a fiduciary must discharge his or her duties with the care, skill, prudence and diligence that a prudent person acting in a like capacity would use in the conduct of an enterprise of like character and aims o For PPR, must be an investment strategy whereby pension assets are invested prudently as someone would do in the conduct of his own affairs • PPR has generally been economically superior approach, permits funds to attain the frontier of efficient portfolios and optimize risk-return tradeoff given the maturity of the fund and its risks • PPR allows a free market to operate throughout the investment process, while ensuring an appropriate level of risk. • By focusing unduly on the risk and liquidity of individual assets, QAR fails to account that default risk and price volatility can be reduced by diversification • PPR: presumption that diversification of investments is key indicator of prudence • The last several years have seen a broad shift from QAR to PPR.

Answer 73

• Prudent Delegation o If plan administrator determines it does not have structures, processes, resources, skills, knowledge and expertise in place, it would be prudent for the plan administrator to delegate these tasks to parties with sufficient skills, knowledge and expertise o Plan administrator must be prudent when delegating functions, remains responsible for delegated activities, should monitor and review • Risk Tolerance o Risk should be managed by taking into consideration plan’s investment and funding objectives when setting and implementing the investment policy, and evaluating ongoing performance of the fund and effectiveness of the investment policy • Investment Policy/Statement of Investment Policies and Procedures o The investment policy, which may include the SIP&P, guides investment decision making and sets out how plan administrator is to comply with investment principles that:  Identify investment types that could be held, allocation, and expected return • Monitoring o To monitor the pension plan and fund for compliance with statutory requirements, sufficient information should be provided to appropriate individuals, and an effective reporting and disclosure regime is needed o Appropriate mechanisms should be in place to monitor a transaction or investment

Answer 74

• Exercise prudence in selection of the investment manager. o Investigate qualifications, assess that there are appropriate structures and resources • Ensure that the assets are invested in accordance with the Investment Policy Statement. o Governance documents should be updated to clearly set out the authority to delegate the investment function, clearly set out terms of delegation • Exercise prudence in instructions given to the investment manager (complete/accurate info) • Have processes that include due diligence in selecting, reporting, and monitoring investments. • After delegating, still responsible for the actions of the new investment manager. o Exercise prudence in supervising manager, monitoring, reviewing delegated activities o Monitor performance of manager to ensure still acting in participants best interest

Answer 75

• MVA is the current fair value of assets of the pension portfolio o Should not include smoothing adjustments, which would mislead investors as to the actual funds available to secure member benefits • Liabilities should be marked-to-market o Without salary projections, at discount rates based on prevailing corporate yield curve o FE treats accrued benefit obligation as the economic pension liability o No liability is held for expected future cash compensation increases • Market Liability o Determined as market value of a reference portfolio comprised of traded securities  Matches the benefit stream in amount, timing and probability of payment o Determined by looking at how financial markets price similar cash flows • Solvency Liability o Determined as market value of portfolio comprised of risk-free traded securities  Matches benefit stream in amount/timing but payment assumed to be certain  Equivalent to an annuity quote, PBGC vested liability or ABO at riskless rate o Difference between market liability and solvency liability is default risk • Budget Liability o Traditional actuarial accrued liability, used to budget cash contributions o Uses discount rate based on long-term expected return on assets  Reflects a “risk charge” (anticipated equity premium) o Can lead plan sponsors to under-appreciate or be unaware of the risk they carry

Answer 76

o Should be discounted at expected return of assets in cash-flow matching portfolio o Could use risk-free rate only if the matching portfolio is 100% risk-free bonds o Pension funds cannot be invested in 100% risk-free bonds: insufficient long-term risk-free bonds to replicate ongoing pension plan liabilities o Pension payments are not fixed and are more variable than bonds o Different types of pension liabilities should be discounted using different discount rates  Market liability: look at how markets price similar cash flows (debt market)  Solvency liability: market value of a portfolio with certain payments that are comprised of risk-free traded securities, might be discounted at risk-free rate  Budget liability: traditional actuarial accrued liability, should be based on the long-term expected return on the pension assets

Answer 77

• Advantages to moving 100% into bonds: o Increased Security for Participants - Matching pension assets and liabilities increases security since any change in liabilities is matched by an equal change in assets o Reduces Investment Management Fees o Reduces risk to shareholders of having to make up any future deficit • Tax Arbitrage - Financial economics argues shareholders are better off if the pension plan holds higher-taxed investments (bonds) and shareholders hold lower-taxed investments (equity) • Plan sponsors should “de-risk” their pension plans and take risks where the market will compensate them, in their core business o Equity investment, higher expected returns, invites underpricing of pension liabilities o Weak sponsors with underfunded plans should invest entirely in stocks, while strong companies or companies with well-funded plans should invest entirely in bonds

Answer 78

• Transparency: transparency is assumed to exist between shareholders and pension funds. o Shareholders cannot see pension plan assets, liabilities or cash flows on a timely basis o Pension expense is based on smoothed asset values with gains and losses further smoothed • Corporate Valuation: shareholders can value corporations economically by reference to the capital markets o Shareholders will not always include value-adding transactions in their valuation of a company • Risk: rational investors will adjust their own portfolio to their desired level of risk o Smoothing mechanisms in current contribution and accounting calculations mute the risk of holding equity investments in the pension plan • Default: promised benefits will be paid by the plan because it remains sufficiently funded and/or the corporation is strong enough to make up any pension deficits o When PBGC is added to the model, it differs from case-to-case o Since there is a PBGC put (floor), sponsors can be more aggressive in investing

Answer 79

• Financial economists have questioned the efficient market hypothesis (EMH) • If EMH is incorrect, then actively managed funds should easily outperform passive index funds which are based on market indices o But professional investors do not beat the market: average active manager underperforms since expense ratios are higher for actively managed funds • EMH says equity prices adjust to new information without delay: no arbitrage opportunities exist to allow investors to achieve above-average returns without above-average risk o Proponents of passive strategy argue that as stock market becomes increasingly efficient, it is more difficult for investment managers to consistently outperform market • Supporters of EMH argue that security prices reflect all available public information and manager skill cannot generate additional returns • Financial economists question the EMH based on instances where market prices failed to reflect available information. o Periods of large-scale irrationality, such as the technology-internet “bubble” o Behavioralists contend markets populated by investors who act irrationally (inefficient market)  Create the opportunities for skillful managers to capture alpha  High dollar minimums make index investing impractical for small pension funds

Answer 80

• Glide path might not be supported by someone who believes in the financial economics approach for funding a pension plan • Pension plans should invest in a portfolio that will match the cash flows of the pension plan o De-risking should be achieved by matching assets and liabilities, using bonds o Optimal cash flow matching should include some equity to the extent that stock will successfully hedge economic risks o Shareholders lose out on tax arbitrage when the plan is not invested in bonds o Portfolio should be rebalanced based on changes in cashflows, not pre-determined trigger points • Shareholder Value: FE understands that firms exist to add economic value, all firm decisions should add value to shareholders o A shareholder can manage own risk by holding more or less risky assets depending on what the plan holds  100% bond allocation for plan creates value for shareholders  Shareholders can take advantage of lower tax on equity earnings • Funding is a corporate finance decision, must be considered independently (outside glide path) o Uncollateralized pension debt should be avoided; plans may want to borrow-to-fund

Answer 81

o Bond Allocation  Pro: Glide path does eventually reach a 100% fixed income allocation, fully de-risked  Con: Strategy could allow for re-risking if funded status declines. 100% funded status is approached over time rather than immediately funded. o Fair Market Value  Pro: Accounting rate may be appropriate if risk of default aligns with bond rate  Con: An ABO measure is more representative of the liability on a fair market value basis o Capital Structure  Pro: Company maintains option to fully fund at any point but not to remove assets from trust for other business needs  Con: Underfunding plan equates to borrowing from plan participants; less efficient than borrowing funds elsewhere and receiving interest tax deduction. o Tax Arbitrage  Pro: Value is eventually optimized once 100% bond allocation is reached; high-tax bond returns sheltered in an account with special tax treatment  Con: Shareholder value is being destroyed during path to full funding. o Debt/Equity Mix  Pro: Shareholders can adjust personal portfolio to reflect plan investments/own risk  Con: Transparent, timely information may not exist to allow shareholders to rebalance o Surplus Ownership  Pro: Risk of trapped surplus is mitigated by full de-risking once fully funded.  Con: Shareholder remain responsible for funding any losses from equity exposure. o Principal-Agent Costs  Pro: De-risking at 100% funded minimizes decisions that don’t optimize value  Con: Glide path utilizes company resources to manage investments rather than focus on the core competency of business o Default  Pro: Equity exposure can be more valuable if sponsor is in poor financial situation; value of PBGC put could be realized  Con: Plan is a pass-through entity and funded status of plan may not represent financial standing of sponsor; limits value of PBGC put

Answer 82

• Interest Rate Risk o Duration mismatch: If pension plan is large relative to company, interest sensitivity of plan may add considerably to overall interest sensitivity of the corporation, which comes from three sources  Business operations  Outstanding balance sheet debt  Pension/OPEB plans o Company can manage this risk by shortening duration of outstanding corporate debt, or lengthening the duration of pension plan assets o Strategies can be executed in cash market or using swaps and/or other derivatives • Credit risk: costly to shareholders since lenders demand higher coupons for riskier debt o Unlike equities (taxed at low personal tax rates), high yield bonds are heavily taxed o Tax considerations point to taking credit risk inside the pension plan • Alpha risk: may be argument for pursuing investments that have lower cost and are better managed than securities for individual investors o Alpha is not correlated to pension plan liabilities, so funded status can vary significantly

Answer 83

• System Discipline o Tight controls over how surplus can be used o Exceptional care if plan is used to achieve purposes beyond ordinary retention/retirement o Additional controls when creating vested promises for future benefit accruals o Plan design features that introduce some blend of risk sharing/management options between investment results and benefits such as those that target benefit levels o Using risk budget to identify potential warning situations o Establishing methodology for responding to yellow flag situations and red flag situations • Pricing discipline o Framework to measure risk inherent in the benefits promise and the strategy used to fund those promises o Use of market value or risk-adjusted assets and liabilities and actuarial values o Use stochastic measurements including fat tails and differences due to long run errors o Use of stress and specific scenario testing o Having appropriate analytics and guidelines when negotiating trade-off between additional benefits relative to current market conditions • Budgetary discipline o Budgetary discipline means aligning revenue to cost o Mature plans: care must be taken to ensure cost variability supported by taxpayers o Risk mitigation by increasing contribution levels may have limitations

Answer 84

• Value-at-Risk Approach o Given time horizon and probability p, VaR is defined as the threshold loss level so that the probability that losses over this time horizon will exceed this threshold level is p o Measure of what the funded status could be under the worst cases in a given period o A market-consistent value of liabilities and market value of assets should be used o Uses stochastic (Monte Carlo) projection to generate many possible economic scenarios and their effect on the funded status o Would put in reserves enough to survive even the 5th percentile scenario, which means there is a 95% confidence that the DB plan will not go under o Most frequently used risk measure, framework for capital requirements under solvency • Traditional Sensitivity Analysis o Sensitivity analysis looks at assumptions that can affect pension plans significantly (e.g., interest rate, salary scale, inflation); determines what impact a change in each of these assumptions would have on the plan o Tries to ensure the plan can survive adverse experience vs. assumptions o Not based on a market-consistent valuation of the pension plan, but can forecast the financial metrics most relevant to corporation/most useful for decision-makers o Pension strategies can be formulated to keep these financial metrics within a certain range, or within a certain level of volatility • Maintaining the same Equity and Debt Beta. ΔE = PA × ΔβPA / βE o A corporation can estimate the amount of equity capital needed to maintain the same equity beta based on an application of the CAPM o A corporation’s beta is a measure of volatility and risk o Changing the plan’s risk profile changes a corporation’s equity beta o By targeting the same equity beta, can solve for the relationship between pension asset and liability beta and the additional amount of required equity capital o By reducing the equity allocation in assets, pension asset beta and required equity capital is reduced, corporation can take more risk in its operating part of the business

Answer 85

• Government / Corporate Bonds: o A bond’s price behaves similarly to the value of pension liabilities in response to interest rate changes. Specific inflation-linked bonds can be used to hedge inflation-linked liabilities o A rise in inflation will increase the value of inflation-linked pension liabilities as well as the inflation-linked bonds o However, there is often a limited supply of these bonds in the market. Using corporate bonds to hedge pension liabilities also introduces credit risk • Swaps: o The pension scheme will typically receive the variable rate and pay a fixed rate. The fixed rate equals what the market expects inflation will average over the life of the swap. o If actual inflation ends up being higher or lower than the pension scheme will receive more or less than the fixed rate they are paying, helping to hedge the inflation-linked liabilities o However, swaps are operationally more complex than bonds and require more understanding and a more sophisticated investor o Counterparty risk exists that a bank defaults and is unable to settle any profit that has accrued within a swap contract o Liquidity issues are also present • Real Estate o Typically a large component of any measure of inflation. Historically there is a positive correlation with inflation and real estate. o Direct real estate, as opposed to REITs, has liquidity concerns that the pension scheme must be comfortable with • Infrastructure: o Includes investments in physical assets such as bridges, roads, highways, airports, etc. o Many of the underlying contracts of these assets have explicit links to inflation, so the value of the assets will increase in inflationary scenarios • Commodities: o Commodity prices, in particular agriculture, are a major component of any measure of inflation. o Typically, commodity prices rise with inflation is accelerating and can therefore provide a good hedge against inflation-linked pension liabilities o Exposure to commodities can be achieved by direct investment, futures contracts, ETFs or less directly through purchase of stocks in companies that produce commodities • Equities: o While not strictly viewed as hedges against inflation, a component of equity returns is tied to company earnings and profitability. Inflationary pressures can be passed onto consumers through prices of goods, and therefore flow through to the company’s revenues and earnings.

Answer 86

• Screening is the application of social or environmental value judgements to the investment process. Negative screens exclude companies that engage in activities that the screener judges to be negative. Positive screens include companies that engage in socially positive activities.

Answer 87

• The attempt by a shareholder to influence corporate behavior through corporate communication, shareholder proposals, proxy voting, and divestment

Answer 88

• The fact of making investments based on environmental, social, or governance reasons, rather than purely economic ones. • Few examples: o Environmental – water and waste management and climate change o Social – human rights and child labor o Governance – corruption and executive compensation

Answer 89

IR = (Rp - Rb) / sigma(p-b) ``` Rp = total actual portfolio return Rb = total benchmark portfolio return sigma = standard deviation ```

Answer 90

WACC = Risk free return + Bassets * (Market return - risk free return) Bassets = (Debt * Bdebt + Equity * Bequity) / Assets

Answer 91

[ (A Std(X))^2 + (B*Std(Y))^2 + 2AB*Corr*Std(X)*Std(Y) ] ^.5

Answer 92

(A*Std(X)^2 + B*Std(X)*Std(Y)*corr) / Std(Tot)

Answer 93

Arithmetic Return - 50% * Variance of Avg Returns

Answer 94

SR = (Rp - Rf ) / sigma (p-f) ``` Rp = total actual portfolio return Rf = risk free return signma = standard deviation ```

Answer 95

Plan Assets * tax spread * bond return * (1-corporate tax rate)

Answer 96

``` k* = k + p * j * (r-i) / s k = expected salary growth p(rho) = correlation coefficient j = std dev of salary growth r = risk-free rate i = expected return of stock s = std dev of stock ```

Answer 97

• Physical goods that are more or less uniform in quality and utility regardless of their source • Typically have higher volatility compared to other asset classes (supply and demand characteristics change frequently) • Ways to invest in commodities: o Direct:  Investing directly in the commodity  Direct ownership, must store  Locate seller, find buyer, delivery logistics  High transaction costs o Futures Contracts:  Using commodity futures contracts to invest  Price change exposure  Can use as hedge, large contract size o ETF Shares:  Buying shares of exchange-traded funds that specialize in commodities  Custom tailored exposure (avoid large contract size, bridges size gap)  ETF caveats, extra fees  Price exposure may not be 1:1 o Purchase commodity company stock:  Buying shares of stock in companies that produce commodities  Own underlying business vs physical good  Invest in industry dominator for most direct  Price exposure not 1:1

Answer 98

* Lack of reliable information * Currency risk, different accounting systems * Poor legal infrastructure, insider trading * Political instability, shareholder rights * Transaction costs, ability to recover investment

Answer 99

• Green Zone Approach: o Identify excess returns statistically different from targeted excess returns o Compare actual tracking error against targeted o Form policies, define deviations that fall outside reasonable expectations o Compile report with results o Green zone:  Within defined expectations o Yellow zone:  Unusual events still expected to occur with regularity o Red zone:  Truly unusual events requiring immediate follow up • Attribution of Returns: o Measures quality, determines source of returns • Sharpe and Information Ratios: o Compare managers within peer group o Test if return compensates enough for risk taken o Can use at portfolio level and individual level • Alpha vs. Benchmark: o Regress portfolio excess return against benchmark o Outputs: intercept (alpha) and slope (beta) o Apply confidence tests to regression outputs and determine if alpha is statistically significant o Can test whether excess return is skill or chance o Easy to calculate o Beta shows if manager used under or overweighting • Alpha vs. Peer Group: o Regress portfolio excess return against peer group

Answer 100

Shares held / daily volume traded

Answer 101

* 3+ diversified investment options * Ability to transfer funds at least quarterly * Plan members have enough information to make informed decisions

Answer 102

* Fiduciary Responsibility – responsibility to plan members & beneficiaries * Governance Framework – establish and document framework for plan administration * Roles and Responsibilities – clearly describe and document all roles and responsibilities * Performance Monitoring – establish and document performance measures to monitor performance * Knowledge and Skills – duty to apply knowledge and skills needed to meet responsibilities * Governance Information – establish and document process to provide appropriate info to participants * Risk Management – establish and document framework to identify and manage plan risks * Oversight and Compliance – ensure compliance with legislative requirements * Transparency and Accountability – transparent communication to plan participants * Code of Conduct and Conflict of Interest – manage conflicts of interest * Governance Review – regular review of governance process

Answer 103

 PPR: A fiduciary is expected to discharge its duties with the care, skill, prudence and diligence a prudent person acting in a like capacity would use.  Delegation: Must delegate to someone with needed authority & skill  Objectives: Need to be well-defined so risks are understood and consistent with objectives  Risk tolerances: Clearly identify risk factors for investments (e.g., liquidity risk), in order to manage those risks  IPS: Create a document that establishes above objectives, principles, asset allocation, and risk tolerances. Also should set out the process for regular monitoring and review, responsibilities for different parties, and process for selecting and replacing asset managers. • Asset allocation: Should reflect characteristics of pension plan liabilities, demographics, and risk tolerances. • Investment selection and due diligence: Use appropriate methods to research in advance and review in hindsight • Monitoring & Documentation: do it

Answer 104

o Right portfolio depends on investor suitability factors that include return objectives, tolerance for risk and cost, and oversight resources o Adaptive skill is the best way to obtain potentially above-market returns o Not all smart beta is created equal o Virtually all investments are active in some way (investors should measure their active risk and make sure they are being compensated for it) o There are several possible approaches to factor investing o Factor strategies go in and out of favor o Many risk factor return premiums have survived for a long time o Factor outperformance is driven by market mistakes and risk o Certain risk factors have outperformed in the long run o Returns to rules-based investing are mostly driven by exposure to factors

Answer 105

• Derivatives meet the needs of those who wish to discover information, speculate, and hedge • Types of Derivatives: o Used to manage interest rate risks:  Futures, forward contracts, swaps o Hedging Strategy (limitations of fixed income) • Advantages: o No up-front capital o Useful ERM tool o No need to sell existing equity/bond positions o Have long target durations – facilitate customized LDI • Disadvantages: o Counterparty risk, liquidity risk • Risks: o Market, liquidity, counterparty, basis, operations, system • Best Practices: o Quantify potential risks o Use third party to value derivative periodically o Attain legal review o Limit exposure to 10% of assets

IRM Flashcards

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