Risk appetite of an institution depends on
- Nature of the institution
- Constraints of its governing body and documentation
- Legal or statutory controls
Main factors influencing a long-term Investment Strategy:
- The nature of the existing liabilities – are they fixed in monetary terms, real or varying in some other way?
- The term of the existing liabilities
- The currency of the existing liabilities
- The level of uncertainty of the existing liabilities – both in amount and timing
- Statutory, legal or voluntary restrictions on how the fund may invest
- Statutory valuations and solvency requirements
- Tax – both the tax treatment of different investments and the tax position of the investor need to be considered
- The size of the assets, both in relation to the liabilities and in absolute terms
- The expected long-term return from various asset classes
- Future accrual of liabilities
- The existing asset portfolio
- The strategy followed by other funds
- The institution’s risk appetite
- The institution’s objectives
- The need for diversification
Factors to be considered before making a tactical asset switch
- Level of the free assets
- The expected extra returns to be made relative to the additional risk
- Constraints on the changes that can be made to the portfolio
- Expenses of making the switch
- Problems of switching a large portfolio of assets
Factors an individual should consider before making an investment decision
- Nature of assets and liabilities
- Cashflow requirements
- Variability of market values
- Returns earned on various asset classes
- Investment freedom and constraints
- Practical considerations
Regulatory framework for investments:
- Restrictions on the type of asset the provider can invest in
- Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency
- A requirement to match assets and liabilities by currency
- Restrictions on a maximum exposure to a single counterparty
- Custodianship of assets
- A requirement to hold a certain proportion of total assets in a particular class – for example government stock
- A requirement to hold a mismatching reserve
- A limit on the extent to which mismatching is allowed at all
Problems with precise matching
- Uncertainty in timing and amounts of asset inflows and liability outgo
- Assets of long enough term may not exist
- Asset proceeds may exceed liability outgo in the early years
Conditions for immunisation
- Value of assets must be equal to value of liabilities
- Discounted mean term of assets must be equal to discounted mean term of liabilities
- Spread about DMT of assets must be greater than the spread about the DMT of the liabilities
Limitations of Classical Immunisation theory:
• Immunisation is generally aimed at meeting fixed monetary liabilities. Many investors need to match real liabilities. However the theory can be applied to index-linked liabilities by using index-linked bonds.
• By immunisation, the possibility of mismatching profits as well as losses is removed apart from a small second-order effect.
• The theory relies upon small changes in interest rates. The fund may not be protected against large changes.
• The theory assumes a flat yield curve and requires the same change in interest rates at all times. In practice the yield curve does change shape from time to time.
• In practice, the portfolio must be rearranged constantly to maintain the correct balance of:
o Equal discounted mean term
o Greater spread of asset proceeds
The theory ignores the dealing costs of a daily (or even monthly) rearrangement of assets.
• Assets of a suitably long discounted mean term may not exist.
• The timing of assets proceeds and liability outgo may not be known.
