Chapter 19: Actuarial techniques (1) Flashcards
f) Methods of monitoring and controlling exposure to AL mismatching risk
Explain what is meant by asset pricing.
State two main functions of asset pricing models.
Asset pricing models
Asset pricing:
- Systematic determmination of prices of risky assets, such as equities, bonds, and derivatives.
- Price equals the expected discounted payoff from asset.
Functions of asset pricing models:
1. To determine whether an asset is mispriced (and represents a trading opportunity)
2. To determine te price of an asset when there is no market price, eg., unquoted asset.
f) Methods of monitoring and controlling exposure to AL mismatching risk
Distinguish between absolute asset pricing and relative asset pricing.
Give a example of each approach.
Asset pricing models
Absolute asset pricing:
- Prices assets in terms of (exposure to fundamental sources) risky macroeconomic factors that influence asset prices, e.g., inflation, interest rate…
- …unpredictability of these lead to the unpredictabiliy of CF and returns…
- …prices obtained are capable of economic interpretation
- e.g., consumption based models such as the CAPM and Multifactor models and equilibrium models…
- …which predict how prices change if policy or economic strucutures change.
Relative assest pricing:
- Finds the price of one asset in terms of a price of another. it does not say where the price of the other asset comes from…
- …therefore uses little information about fundamental risk factors as possible
- Option pricing models e.g., Black-Scholes
- Term structure models
Generally the price predictions obtained by RAP are more accurate than those obtained by AAP.
f) Methods of monitoring and controlling exposure to AL mismatching risk
State the general asset pricing formulae
Asset pricing models
(1) p (t) = Sum_i to infinity [E(m(t+i)*x(t+i))]
The price of an asset is equal to the expected present value of discounted CF, a fundametal idea of asset pricing
(2) m(t+i) = f(data, parameters)
tells us where the stochastic discount factor comes from.
Derived from economic model and/or empirical data and differs between different asset pricing models.
where:
- p(t) = price of the asset at time t
- x(t+i) = asset payoff at time t+i
- m(t+i) = stochastic discount factor (or state price deflator) for the interval t to t+ i.
f) Methods of monitoring and controlling exposure to AL mismatching risk
Outline how ALM is used for:
- banks
- pension funds and insurers
- institutional investors
ALM
Banks
- ALM is used to describe a processs that actuaries would regard as closer to matching —> ensuring that any mismatches are not so large as to expose them to serious risk if there is a sudden sharp market movement
- VaR is used to quantify these risks
Pension funds and insurers
- ALM is used to investigate long-term issues such as (Matching CF, Interest Rate risk, inflation risk, demographi risk, longevity risk
- –> the carrying out of projections of assets and liabilities (and related charateristics such as solvency) over several years
Insitutional investors
1. Used when setting investment strategy.
2. Historical results of ALM
- a benchmark consisting of specific (fixed) % allocated to each asset class which the manager is expected to follow (within suitable ranges –> load differences and load ratios)
- extraction of a ‘core’ pf, typical of bonds, with the remaining assets invested in a ‘balanced’ fashion
2. The above benchmarks are static and are not directly linked to the performance of liabilities
-…this has resulted in LDI gaining traction
-…Where the benchmark for investing the assets changes as the underlying liabilities change –> this benchmark is referred to as ‘dynamic liability’ benchmark
f) Methods of monitoring and controlling exposure to AL mismatching risk
List the main stages in an asset liability modelling (ALM) exercise.
ALM
- Key objectives of the investment policy (and funding policy) should be set up
-…future funding levels
-…future solvency levels
-…future contribution rates
-…Level of risk accepted - Determine suitable assumptions to use in the ALM exercis.
-…interest rate & inflation assumptions (dynamic links)
-…Other assumptions affecting assets and liabilities individually - collect data to carry out projections
- consider the overall nature of the liabilities
-…current funding level
-…maturity and CF projections under different scenarios - Consider future progress of the fund under different investment strategies
-…use an asset model and produce stochastic simulations of returns - Analyse different asset mixes in more detail to assess the risks (relative to the liabilities) and rewards of each alternative.
- Summarise and present results, often graphically.
- Choose the investment strategy.
f) Methods of monitoring and controlling exposure to AL mismatching risk
List the extra dimenstions of information provided (ALM) exercise compared to a traditional actuarial valuation.
ALM
- Providing projections into the future (time dimension)
- Providing some estimates of the range of likely outcomes (probabilistic dimention)
- indicating the effet of changing investment strategy (asset mix dimension)
f) Methods of monitoring and controlling exposure to AL mismatching risk
Give an example of a typical objective for a pension fund.
ALM
- maximise the expected surplus of assets over liabilities at the end of a five year period (time horizon), with both asset and liability values calculated on a consistent discounted CF basis (how A and L are valued), subject to:
- ensuring that the value of A exceeds 110% of the value of L at each point during the five-year period with a probability of 99%
f) Methods of monitoring and controlling exposure to AL mismatching risk
Outline the ACC for ALM.
ALM
-Specify the problem
-…P[Insolvency] = P[Available economic capital < 0] <= 0.5%
-…At the end of each financial year
-…Over a N year projection period
-…(VaR Solvency II - the problem is an example of this)
- identifying the solution
-..Model choice for both assets and liabilities = model risk (consider)
-…Parameter choice = parameter risk
-…Collect asset and liability data
-…Broad analysis of nature, term, currency and certainty of asset and liability cash-flows
-…Project assets and liabilities into the future
-…Determine asset mixes that meets the objective
- Monitor experience
-…Re-specifying the problem or solution design
-…Frequency of modelling
-…Presentation of results to decision makers may result in changes
-…Presentation of ALM results…
…Usually graphical funnel of doubt
….Risk/return trade-off
f) Methods of monitoring and controlling exposure to AL mismatching risk
Outline the different ways in which results can be summarised and presented
ALM
- In graphic format –> looks at distribution of a target objective (solvency or fundingg level) resulting from a single investment strategy over the projection period
- Not fully hedged A & L (median outcome) –> show a range of results (funding levels) based on projected A & L performance on different economic scenarios ( e.g.,using different investment strategies for a median outcome
- select single projection date –> plot favourable, unfavourable and median results using asset mix as variabe on the horizontal axis
Strategies designed to hedge liabilities (partially or fully) –> funnel of doubt narrow than strategy with significant mismatch of A and L
f) Methods of monitoring and controlling exposure to AL mismatching risk
List the advantages and disadvantages of using shortfall probabilities to choose between investment strategies.
ALM
Advantages:
- simple to calculate
- simple to understand
- benchmark can be chosen to reflect attitude to risk.
Disadvantages:
- ignores the extent of the shortfall
- ignores the extent of the upside (A high shorfall probability than B but could lead to higher surplus)
- difficult to estimate accurately
- cannnot place ‘value’ on investment strategy
- ignore the impact of investment strategy on external stakeholders in investment fund.
Additional Considerations:
- ALM typically uses shortfall probability alongside other risk measures like Value at Risk (VaR) or Expected Shortfall (ES) to get a more comprehensive picture of risk.
- **Stress testing ** can be used to assess how different investment strategies perform under various economic scenarios.
- ALM is an ongoing process, and shortfall probabilities should be re-evaluated and adjusted as economic conditions and the institution’s circumstances change.
f) Methods of monitoring and controlling exposure to AL mismatching risk
Explain what is meant by:
- asset liability mismatch reserving
- resilience testing
ALM example: Asset/liability mismatch reserving
Asset liability mismatch reserving
- projects emerging asset and liability positions under range of possible conditions to establish the extent to which assets and liabilities mismatched.
- Appropriate supplementary reserves then set up to cover possible levels of shortfall identified.
Resilience testing
- Assess resilience of investor to sudden changes in market conditions
- e.g., immediate fall of 25% of equity prices and immediate increase/decrease of 1% in bond yields.
