1
Q
What is the risk budgeting process
A
- Define a feasible set of assets
- Choose an initial asset allocation using a risk optimiser and a value at risk assessment to determine risk tolerance
- Monitor risk exposure
- Rebalance the portfolio once necessary
2
Q
What are the ways to identify price anomaly
A
- Monitor price ratios between bonds, and look for sharp movements that may be reversed.
- Monitor yield differences between bonds and look for sharp movements that may reverse over time, offering the potential to make a profit.
- Develop a price or yield model to determine the theoretical price of each bond, which can be compared to the market prices.
- For example, the theoretical prices of each bond may be calculated by discounting the cashflows at a yield that reflects the marketability and exact duration or weighted mean term ofthe bond
3
Q
Additional factors to consider when engaging in price anomaly
A
- Regulatory restrictions, or self-imposed restrictions in the investment mandate
- Authority to make a switch of the size planned.
- Tax implications - what are the ‘net’ redemption yields of both bonds at the institution’s income tax rate?
- Costs and expenses incurred (for example dealing costs, bid/offer spreads …)
- Pushing prices against the switch when dealing in very large size
- There should be little change in maturity for an anomaly switch, but if there is a small change, the impact on the matched position of the fund should be considered.
- Anomaly switches are often reversed, and the costs and market impact of reversing the switch at a later stage should be considered.
4
Q
Advantages and disadvantages of using CDS
A
Disadvantages of using CDS
- Relatively little experience and expertise is required to invest a portfolio in corporate bonds.
- Corporate bonds pay a regular coupon, whereas CDSs only pay the credit premium. (However, if the funds are invested elsewhere, for example a government bond) in addition to the CDS agreements, then cashflow may be derived from this which will complement the CDS premium income.)
- Corporate bonds do not require any ongoing management. CDSs may be shorter-term, and require rolling over on a regular basis with all the costs and risks that this entails.
- Corporate bonds expose the scheme only to the risk of the bond issuer, whereas credit derivatives involve exposure to the reference bond counterparty, the credit derivative counterparty (in the event that a default occurs). lf the surplus funds are invested in government bonds, there will also be an increased risk to the government.
- Regulatory risks and costs will be less than on a portfolio of credit derivatives
- Collective bond schemes exist that are managed by professional managers if the scheme wishes to avoid bond selection activity (egfor a smallfund with limited expertise).
Advantages of using CDS
- CDSs are swap agreements and can be complex and involve legal risk. They can be expensive to manage on an ongoing basis. ln particular ISDA agreements would need to be signed by the trustees.
- There may be mandate restrictions that restrict the scheme from investing over a certain proportion directly in corporate bonds. These may not exist for credit derivatives.
- There may be collective vehicles that offer diversified and managed CDS portfolios. lf the scheme is small, these ClVs may be particularly attractive. (*)
- There may be a greater universe of bonds that can be referenced under a CDS, than there are investible corporate bonds in the bond market. This will result in greater diversification and less specific risk. (*)
- Credit derivatives may be more marketable than corporate bonds. (x)
- There may be tax benefits for one or other strategy. CDSs may overcome certain regulatory or accounting hurdles (or vice versa)
- Credit derivatives can enable gearing to enhance returns. This could be carried out, for example, by simply selling CDSs on more nominal reference bonds than the scheme would otherwise be able to afford if it invested in corporate bonds. This brings extra premium income, but exposes the scheme to extra risk.
- CDSs can be flexibly designed to match the term and duration requirements of the scheme. Corporate bonds exist only in a certain range of maturities
5
Q
What is included in the mandate
A
- The benchmark asset allocation that the investment manager will be measured against.
- Risk parameters relative to the benchmark that the manager will be measured against and should not breach.
- A statement of the manager’s approach to achieving the objective stated, within the risk guidelines.
- Methods of performance measurement, and timescales for reporting.
- Restrictions on certain investments and investment categories.
- Ethical and environmental issues and the approach to socially responsible investment.
6
Q
State the steps that need to be taken to construct a model
A
- Clarify the objectives of the asset-liability modelling, eg over what time period is the risk of insolvency to be assessed.
- Establish suitable assumptions to use, eg distribution of returns for each asset class.
- Collect data on the liabilities in order to carry out the projections.
- Produce projections of the liability cashflows under multiple scenarios.
- Project the assets under multiple scenarios and analyse the impact of changing the investment strategy on future values of the assets.
- Analyse different asset mixes in detail to assess risks and rewards relative to the liabilities.
- Summarise and present the results.
7
Q
The advantages and disadvantages of Cashflow matching using bonds
A
- lnvest in a portfolio of government bonds of appropriate duration and currency to meet the annuity payments.
- A relatively simple approach, if appropriate bonds are available.
- lndex-linked bonds could be used to match annuity payments that are linked to the Retail Prices lndex.
- Government bonds offer low credit risk.
- The hedge is easy construct and to unwind as government bonds are very widely traded.
- The insurance company is likely to have sufficient expertise to enact this strategy and so it is likely to be permitted by any investment mandate it may have.
- Repo contracts could be used to fund the hedge if sufficient funds are otherwise unavailable.
Disadvantages
- ln order to hedge fully using only government bonds, the insurer needs sufficient funds to invest in a bond portfolio that is equal to the present value of the liability cashflows discounted at bond yields…
- …sufficient funds may not be available as the insurer is struggling to maintain adequate capital reserves.
Bonds available may be too short… - …in which case, the longest duration liabilities will be unhedged and the insurer will retain some interest rate risk.
- The liability cashflows may not be matched perfectly because
- of the residual credit risk in some government bonds
- bonds may not be available at all durations ie there may be gaps in the range of bonds…
- … particularly with index-linked liabilities as the range / number of index-linked bonds is generally relatively limited.
8
Q
Advantages and disadvantages of using swaps
A
Advantages
- Use swaps to match the annuity cashflows.
- For example, the insurer could hedge the interest rate risk from level annuities by entering swaps where it makes payments linked to floating interest rates and receives fixed payments.
lnflation-linked payments can similarly be hedged using inflation swaps in combination with interest rate swaps.
- Advantages of swaps over
- lnterest rate and inflation swap markets may have longer maturities available than bond markets’
Swap markets may have greater liquidity… - …and lower transaction costs than bond markets.
- The insurer doesn’t pay the principal underlying the swaps, only the regular payments, so swaps can be arranged even if the insurer’s funds are lower than the present value of the liabilities’
- Swaps are over the counter arrangements and therefore, unlike most bonds, the payments can be tailored to better match the liability cashflows.
- The costs of closing out swaps can be lower than the transact¡on costs of selling a government bond.
Disadvantages
- The insurer will need to meet the swaps’ collateral requirements, which may require daily or weekly payments.
- The insurer will be exposed to the credit risk of the swap counterparty…
- …although collateralisation will limit losses if default occurs. But new swaps will then need to be put in place at potentially higher cost.
- The insurer will need to make payments based on a floating interest rate and is exposed to the risk that its assets generate insufficient return.
- The insurer and swap counterparty will need to negotiate and agree ISDA documentation…
- …which can be expensive and time consuming.
9
Q
How do you protect yourself against rising asset price
A
- An investor expecting a large cash inflow in the future may wish to protect against a rise in the market by buying futures.
- The manager could buy sufficient futures contracts (ie equivalent in value to the expected cashflow) such that if prices did rise they would make a profit on the futures equal to increase in the cost of buying the underlying assets.
- The futures contracts would be based on an equity index that was expected to move in line with the equity fund.
- buy call options - use the profits from a call option at a suitable strike price to offset any increase in value of the equity assets. This would incur a (large?) premium, but would not incur a loss if the equities fell in value.
10
Q
What is basis risk
A
- basis risk - the risk that the basis (the difference between the futures price and the spot price) may change over time.
- This occurs becuase the future risk free rate and dividend income yielded by the index cannot be predicted exactly, mean that the basis canot be predicted exactly
- This is a particular risk if the date of the expected cashflow is uncertain, and the future may need to be closed out before expiry or rolled over to due to uncertainity about the settlement date.
11
Q
Alternative reasons for hedging
A
- The purpose of hedging is to reduce risk and to make the financial outcome more certain.
- For example, the fund may be expecting to disinvest a large sum of money in the future and wants to protect against the risk of a fall in equity values (in which case it could sell index futures).
- Alternatively the manager may be attempting to adjust the risk profile of the fund to better match the assets (ie reduce actuarial risk)orto reflect a change in risk appetite or investors (in which case it could sell a smaller proportion of index futures).
- The manager might be attempting to gain relative outperformance and may use index futures to remove the risk of market movements.
- Using derivatives may be cheaper or more efficient than transacting in the underlying assets,
12
Q
Passive and active risk
A
Advantages of passive
- lower risk of (substantially) under-performing the index in question - and your competitors.
- lower portfolio management costs - ie lower dealing and research costs.
- the fund itself is well diversified, so reducing spec¡fic risk and hence the volatility of portfolio returns.
Disadvantages
- loss of potential upside
- it may be difficult to find an appropriate index to track, eg the indices available in an emerging market may include shares that cannot be purchased by non-residents .
- it may be difficult to track the chosen index, eg in the property sector.
Advantages of Active
- A skilful investment manager may be able to out-perform both the index and the competition in an inefficient market ¡
- reduces relative performance / peer group risk
Disadvantages
- higher costs (dealing and research costs)
- it may be difficult to select a suitably skilled investment manager
- timing the changes to the line-up of active managers is also very difficult.
13
Q
What is policy switching
A
- Policy switching involves taking a view on future changes in the shape…
- …or level of the yield curve…
- …and moving into bonds with quite different terms to maturity…
- …and / or coupon.
14
Q
Three techniques to identify bond policy switching
A
Volatility
- Calculations of volatility or duration…
- …together with forecasts for changes in yield at different points along the yield curve can be used to estimate percentage changes in value,..
- …and so to determine the area of the market which will give the best returns.
Reinvestment rates
- ldentify the yields on two bonds of different terms to maturity.
- Compute the rate at which the proceeds of one bond would have to be reinvested…
- ..,up to maturity of the longer term bond, to match its yield.
Spot rotes and lorward rates
- Derive forward and/or spot rates from the yield curve.
- This may reveal oddities in the term structure of interest rates which give rise to a policy switch opportunity.
15
Q
What are the financial risk and what are the solutions
A
- Market risk - the risk relating to changes in the value of the portfolio due to movements in the market value of the assets held.
- Credit risk - the risk that a counterparty to an agreement will be unable or unwilling to fulfil their obligations.
- Operational risk - the risk of loss due to fraud or mismanagement within the fund management organisation itself.
- Liquidity risk - the risk of not having sufficient cash to meet operational needs at all times. lt is related to market risk in as much as the liquidity of the overall portfolio is need to be taken into account in portfolio selection.
- Relative performance risk - the risk of under-performing comparable institutional investors.
16
Q
What are the limitations of VAR
A
- VaR calculations usually assume normal distributed returns in order to make the mathematical calculations tractable. Most markets exhibit skewed returns in reality, and the difference this makes when working in the extremes of the tails of distributions can be very large indeed.
- Expected returns, variances of returns and correlations between returns are usually determined by looking at past data. The past is rarely a good guide to the future, and particularly in market crash situations, correlation statistics can be very variable.
- There may be a lack of past data available to model extreme market movements re the tail of a distribution.
- Portfolios that are exposed to credit risk, systematic bias of derivatives often exhibit very skewed distributions.
- ln these circumstances VaR may only be useful if the model can incorporate the skewness of the market returns. This will usually involve Monte Carlo modelling.
Correlations between asset classes often becomes high (ie ‘1’) when markets crash. - Many inputs can be subjective, and models can be complex and potentially misleading.
VaR looks only at downside risk, ignoring the upside potential.
17
Q
What is VaR
A
It is the max potential loss on a portfolio over a given future time period with a given degree of confidence (1-p). It is oiften calculated assuming that investment return follow a normal distrubution , which may not be an approrporate assumption.
18
Q
What is cross hedging risk
A
- In practice the mix of assets athat constitute the index upon which the index future is based on not be identical to the actual portfolio that the invesetor is trying to hedge
- As a consequence, movements in the theoretical value of the future will not mirror those of the investor’s portfolio exactly. The resulting and unpredictable profits or losses are known as cross hedging profits of losses
- In addition hedging may not completely eliminate the profits and losses if only part of the portfolio is hedged, so leaving a net positive exposure to market movements
19
Q
How futures are used to protect portfolio
A
- It involves taking a position in the index future that is opposite to the position held in the equity market
- The idea is that a loss of profit made in the equity market will be counter balanced by a profit or loss on the future
- The choice of equity index futures used will reflect the structure of the portfolio being hedged
- for example, a portfolio of large UK equities would be hedged using the FTSE 100 index future
- Short hedge: investor can product against a market fally by selling index futures
