Asset Liability Management

Explain the characteristics of a credit default swap (CDS).

- A credit default swap (CDS) is one of the most common credit derivatives - A CDS is a credit-derivative contract where the credit-protection buyer makes a series of cash payments to the credit-protection seller in exchange for a guarantee of compensation against adverse credit events related to a third party. - CDS can be seen as an insurance policy on a credit event related to a third party. - The payment from the seller can take several different forms: 1. A payment reflecting the difference between the expected and actual values of an underlying asset due to a default; or 2. The protection buyer could transfer the defaulted asset to the protection seller in exchange for the original principal amount - CDS dealer enters into the agreement having done enough due diligence on the borrower that is willing to accept the risk of the borrower defaulting or, instead, it is comfortable that it has diversified its risks enough to take on this exposure. - Similar to an insurance company where the insurer is responsible for determining whether total premiums collected will be sufficient to cover the claim payments (and holds appropriate reserves and capital to guarantee this) as part of its underwriting process - CDSs operate in a similar way in that CDS writers have to be able to recognise when their risk exposure is too concentrated. - If they do find themselves in such a position, they need to purchase CDSs from other dealers to transfer some of the risk or find alternative avenues, much the same as insurers transferring some of their risks to reinsurers.

Explain the characteristics of credit derivatives.

- A credit derivative is an OTC or exchange-traded derivative contract where a credit protection seller provides protection against a specific credit event loss to the protection buyer. - Credit derivatives create obligatory transactions for both parties so are forward commitments - There are uncertain outcomes or contingent events affecting the credit derivative but the agreement itself is obligatory. - The underlying security (e.g. a corporate bond in the case of a total return swap) may or may not default but both parties to the credit derivative continue with their agreed transactions - Initially credit derivatives took the form of total returns swaps, where the cash flows associated with one underlying asset were exchanged with another. - The credit-protection buyer would pay the seller the total return on the underlying asset, which inherently has credit risk, and in exchange the seller would pay the buyer an alternative series of cash flows based on a fixed or floating interest rate. - If the underlying asset defaults (e.g. corporate bond) then the credit-protection seller has to continue making contractual payments whilst receiving very low, if any cash flows from the credit-protection buyer.

Explain the characteristics of a credit spread option.

- A credit spread option is another type of credit derivative where the underlying asset is the yield (credit) spread on a bond. - Spread represents the difference in risk between the bond's yield and the benchmark risk-free yield to compensate investors for the additional credit risk. - Credit spread is a reflection of the market's perception of credit risk. - This type of derivative only works if there is a quoted (i.e. traded) bond, as it requires the credit spread of the underlying bond to calculate payoff profiles and assess credit events. - Credit-protection buyer will agree to the strike price and pay an option premium to the protection writer. - At the strike date(s), parties will assess if the option is in the money through comparing credit spread with strike spread. If it is in the money, the writer will pay the buyer accordingly. - A credit spread is therefore a call option on the underlying credit spread.

Define and describe the characteristics of a derivative.

- A derivative is a financial instrument whose value depends on the value of the underlying asset. - The prices of underlying assets (e.g. equities, fixed income securities, commodities) are called spot prices or cash prices. - Derivatives facilitate a transfer of risk from one party to another. - Derivatives specify the underlying instrument and define the events that cause a payment to be made. - Derivative contracts are legal contracts that involve two parties: the buyer and the seller. - The buyer is referred to as the long party or the holder because they own (hold) the derivative. - The seller is referred to as the short party or the writer because they have sold the derivative. - A derivative contract will specify the rights and obligations of all parties involved. - Some derivative contracts can be traded on an exchange, which will impose restrictions on the contract. - Direct trading between two counterparties, with potentially highly customisable contracts, occurs over the counter (OTC). - In general, derivatives can be classified as: 1. Forward commitments - an obligatory agreement between parties to transact at a future date(s) at a specified price. This include futures contracts, forward contracts, and swaps. 2. Contingent claims - an agreement that provides the claim holder (i.e. buyer) the right without the obligation to transact at a future date(s) at a specified price. This includes options and asset-backed securities. - Hybrids are derivatives that cannot be classified as forward commitments or contingent claims. - Derivative contracts tend to have high levels of leverage or gearing. Only a small initial payment is needed through a margin requirement and/or a premium to enter the contract.

Describe the characteristics of forward contracts.

- A forward contract is an OTC derivative contract where two parties agree to exchange an underlying asset at a specified time in the future for a specified price, all of which is agreed at the point of entering the contract. - OTC contract; not traded on an exchange - Parties will agree on price, expiration date, and other terms of the exchange - A forward contract is an obligation and each party to the contract commits to honouring that obligation - Failure to do so will result in a party defaulting, with the other party potentially taking legal action to enforce the contract - Both parties face counterparty risk at the point of entering the contract, but as time elapses one party will have an unrealised gain and as a result have more counterparty risk in that they would be unable to receive the profits from the trade if the counterparty defaults. - An important feature of forward contracts is that no money is exchanged at contract outset. This contrasts with the purchase of the underlying asset where cash is exchanged equal to the then price of the underlying asset. - The consequence is that a forward contract has a zero value at time otherwise, an arbitrage opportunity would exist. - The derivative value only starts becoming an unrealised profit to the one party and an unrealised loss to the other party as the value of the underlying asset changes over time. - Forward contracts do not have to result in physical delivery of the underlying asset or even the electronic transfer of ownership of the underlying asset. Instead, the contract can be settled through a cash exchange to reflect the change in price. These derivatives are known as non-deliverable forward contracts (NDFs). - Such cash-settled forwards and contracts for difference provide the same ultimate financial outcome for an investor as a forward that takes actual delivery at expiration.

Describe the characteristics of futures contracts.

- A futures contract is a standardised exchange-traded derivative contract where two parties agree to exchange an underlying asset at a specified time in the future for a specified price, all of which is agreed at the point of entering the contract. - Futures are very similar to forward contracts - except that all the terms are standardised, and they are traded on exchanges. - Through standardising the futures and trading them under a central clearing facility with rules and regulations, the futures contracts potentially have more liquidity as well as the additional benefit of being indemnified by the clearing house against defaults. - Futures exchanges are highly regulated across the globe and only allow certain contracts to be traded. As these contracts are standardised, they have less flexibility compared with forward contracts. - Standardisation of exchange-traded futures contracts extends to specifying the underlying assets, time(s) to expiry, delivery, and settlement terms, as well as the units or quantities for trading. - Since futures are transacted on an exchange, there is no need for the two counterparties to know of each other's existence. - Formally, a clearing house acts as an intermediary. The clearing house sells the contract to the long position and buys the contract from the short position. - At contract maturity, the clearing house is obligated to make the delivery to the long position and pay the short position. - Thus, clearing house takes all counterparty risk. - Clearing house makes a profit by charging a small transaction fee per contract. - No money is exchanged when futures contract is initially agreed. - Consequently, value of the futures price should initially be zero to both parties. - Investors in futures contracts tend to collect their daily profits and pay their losses with no intention of taking actual delivery of the underlying asset. - As part of negotiating the terms the parties would decide on physical delivery or cash settlement at expiration. - For futures, the exchange would specify, as part of standardising the contracts, whether physical delivery or cash settlement is applicable. - Similar to forward contracts, rising prices are beneficial for the long party and costly for the short party. The reverse is true when prices are falling.

Explain Prospect Theory.

- A key finding of Prospect Theory is that people seek to maximise utility, defined in terms of changes in wealth around a reference point rather than the level of wealth. - The utility or value function is assumed to be steeper in the domain of losses than gains, contributing to loss aversion. - People are more sensitive to losses relative to their starting point than they are to gains relative to the same starting point. - This explains the disposition effect where investors are inclined to sell their winners and hold their losers too long to postpone the regret of incurring a loss. - Under EUT, the utility curve of a risk averse investor has a concave shape as a gain of $1000 increases utility less than reduction in utility from a loss of $1000. - Under Prospect Theory, utility is not dependent on the level of wealth but varies according to changes in wealth. - Prospect theory also includes the concept of probability distortion, which is based on the observation that people attribute excessive weight to events with low probabilities and insufficient weight to events with high probability. - In practice, the point at which probability goes from overweighted to underweighted is difficult to ascertain. - Prospect theory describes the investor's decision-making process as comprising two phases: 1. An initial phase called editing or framing; and 2. An evaluation phase - The editing or framing phase occurs when outcomes of a decision are initially appraised and ordered according to a certain heuristic - also known as a rule of thumb. - Investors decide which outcomes are considered equivalent and set these as the reference point. They then consider lesser outcomes as losses and greater outcomes as gains. - There are two phenomena that occur within the editing process: 1. Acceptance - whereby people are unlikely to alter the formulation of choices presented; and 2. Segregation - whereby people tend to focus on the most 'relevant' factors of a decision problem. - The evaluation phase occurs when investors choose from the appraised options by assessing the value or utility of each, based on the potential outcomes and their respective probabilities, and select the options with higher appraised utility. - Kahneman and Tversky observed behavioural patterns in people when they evaluated various alternatives. These patterns included: 1. Reference dependence - relates to the observation that people derive utility from gains and losses - as measured relative to some reference point - rather than from absolute levels of wealth. This emerges from the idea that people are more attuned to changes in attributes rather than absolute magnitudes. It generates utility curves with a point of inflexion at the chosen reference point. The reference point and the steepness of the utility curve may also be influenced by the value of the person's wealth. 2. Loss aversion - relates to the observation that people are much more sensitive to losses, even small ones, than to gains of the same magnitude. Thus, utility curves are steeper in the domain of losses than they are in the domain of gains. Individuals tend to be risk-averse in the domain of gains, and risk-seeking when faced with losses as they are prepared to take chances to avoid otherwise certain losses. There is also diminishing sensitivity as we move away from the reference point. As more gains or losses are made, the marginal impact on utility of additional gains or losses falls. Thus, a utility function is concave in the region of gains but convex in the region of losses. 3. Probability weighting - people do not weight outcomes by their objective probabilities. In general, low probabilities are overweighted while high probabilities are underweighted. 4. Isolation effect - refers to the observation that when choosing between alternatives, people often disregard components that the alternatives share and instead focus on what sets them apart, in order to simplify the decision. Since different choices can be decomposed in different ways, this can lead to inconsistent choices and preferences. The combination of overweighting of small probabilities and the concavity or convexity of the investor's value or utility function can lead to a pattern of risk attitudes such as: - Risk-averse behaviour when gains have moderated possibilities or losses have small probabilities (which are overweighted); - Risk-seeking behaviour when losses have moderate probabilities (which are underweighted) or gains have small probabilities (which are overweighted). - An important observation of Prospect Theory is that the way investors subjectively frame an outcome or transaction in their mind affects the utility they expect or receive. - This phenomenon can be seen in practice in the reaction of investors to the effect of stock market fluctuations compared with market movements that affect other parts of their wealth.

Explain the characteristics of swaps.

- A swap is an OTC derivative contract where two parties agree to exchange one series of cash flows for another, each of which has its own reference rate or underlying asset or is otherwise fixed in nature. - One series, also known as a leg of the swap, is floating or variable and is usually based on the movement of the underlying rate or asset. - The other leg of the swap is often fixed, but it can also be variable with a different underlying rate or asset. - Since a swap is OTC, there is flexibility to negotiate and customise terms such as the exact payment dates, underlying assets or rates, and payment process. - As it is traded via OTC market, it faces similar risks as forward contracts in that the counterparty could potentially default. - Payments are always netted down - that is, the funds transferred are always based on the net amount owed by one of the parties at that payment date. At that point in time, the party owing the lower amount cannot default as only the excess payment from the party owing the larger amount is required. - The most common form for a swap is the fixed-for-floating interest rate swap. This is often referred to as a vanilla interest rate swap. - Similar to forwards and futures, there is no transfer of funds at the start of the swap, as the value of the swap is zero upon commencement to both parties. - The fixed rate is calculated to ensure that the value of the swap is zero. - As market conditions change and therefore the value of the underlying asset or rate, the value of the swap will become positive for one party and negative for the other. - As swaps are traded via the OTC derivative market, they are exposed to default risk. - However, as the notational amount is not usually exchanged, the counterparty risk is lower compared to a loan. - If a party defaults at any given point in time, then all the remaining payments would also default, and the value of the loss would not be limited to the one payment but extend to all remaining payments. - Credit risk should be given due consideration - Investor might demand that risk-mitigating measures such as collateral be put in place when entering the swap. - Swaps can take various forms, e.g. an interest rate swap where one party agrees to make payments based on a specific variable rate and receive payments on another variable rate or different currency. - Forwards, futures, and swaps are all forward commitments are can therefore achieve the same outcome. - A series of forwards, for example, could provide the same cash flows as a swap. However, this would require negotiating each forward separately, whereas the swap would be a single contract. - A swap is a multi-period extension of a forward contract

Explain the characteristics of asset-backed securities.

- An asset-backed security (ABS) is a derivative contract where a group of underlying instruments generating cash flows are pooled, and tranches are issued that have different levels of seniority (priority), both in terms of receiving cash flows from the underlying instruments and in absorbing any prepayments or credit losses. - ABS are contingent claims - the claims are the promise of a series of cash flows that are contingent on prepayment and defaults not occurring. E.g. investors holding a certain bond issuance would all have an equivalent claim on the interest and principal repayments and would therefore expect the same rate of return as each other (assuming they all entered issuance at the same price and held to maturity). - If a portfolio of similar bonds were combined into an ABS, certain investors would have claims on the repayments that take preference above other investors. - This becomes important when bonds are repaid early (i.e. prepayments) or if defaults occur. - To determine priority of claims on repayments, claims on the bond portfolio cash flows are divided A, B, and C class tranches. 1. Class C (equity or junior tranche) bears the first prepayments until this equity tranche has been repaid in full, as well as bearing the first defaults until all principal payments have been defaulted on. 2. Class B (mezzanine tranche) bears the next prepayments until it has been repaid in full and similarly any additional defaults until there are no more principal payments at risk. 3. Class A (senior tranche) will receive any additional prepayments until all the principal invested has been repaid in full and similarly any defaults. - Risk exposure for each tranche is very different and investors would expect to earn different rates of returns to be compensated accordingly. - A CDO would structure the underlying cash flows into tranches as mentioned - namely, the senior, mezzanine, or equity tranche. E.g. as homeowners repay their mortgages early to refinance at lower rates, the relevant CMO holders would suffer losses as they expect to receive a certain cash flow stream (consisting of interest and principal repayments) that will no longer be received. CMO holders will have to reinvest the principal amounts (at potentially lower rates). - As defaults are experienced, the junior tranche would absorb the losses first, then the mezzanine tranche, and ultimately the senior tranche. - Returns expected by investors will reflect the credit risk associated with each tranche. - Equity tranche has the highest risk and highest expected return and the senior tranche has the lowest risk and lowest expected return.

Explain the characteristics of options.

- An option is an OTC or exchange-traded derivative that grants the buyer the right to trade an underlying asset at an agreed price at or before the expiration date. - Forward commitments have linear payoffs, whereas contingent claims have more pronounced payoff profiles. - Options limit losses in one direction and provide the opportunity to participate in gains in the other direction. This can occur either when the price of the underlying asset goes up or when it goes down and can therefore transform the payoffs of the underlying assets. - When options are traded OTC, they are more customised and will be subject to counterparty default risk and be less regulated and less transparent compared with exchange-traded options. - Certain options can also be exercised early - the holder of the option may choose when to exercise the option, if this is stipulated in the contract. - If the option holder exercises the option and trades the underlying asset, then they would either be buying or selling the underlying asset. - Call option is the right to buy an asset - Put option is the right to sell an asset - European option - option that can only be exercised at expiry - American option - option that can be exercised early - Options can also be exercised through physical delivery of the underlying asset or cash settled. Type of delivery will be specified in the contract. - Strike price - price agreed that the call buyer pays and the put buyer receives. - Exercising a cash-settlement option results in the option holder receiving the value that is the difference between the asset value and strike price. - Strike price is similar in concept to the forward price. However, forward price is set such that the contract value at commencement is zero for both parties under a forward, whereas the strike price of the option is chosen by the parties involved in the trade. - The actual value of the option can be different from zero at commencement. - As the option holder has the right and not the obligation to exercise the option, the option holder can in fact not default once the contract is entered into and the initial premium is paid. - Only the option writer can default. - This contrasts with forwards and swaps where both parties could default any time.

Explain the process of marking to market.

- As the price of the underlying asset changes each day, the futures value would change, and the daily gains and losses would be calculated via the daily settlement process. - Clearing house transfers funds between parties to reflect daily gains and losses over time. - As this is done daily, the incremental changes are relatively small, and the margin balances supports the clearing house to manage counterparty risk from the party losing money. - The clearing house accepts the counterparty risk and manages that risk through the operation of an initial margin account. - Any trader in a futures contract is required to deposit collateral (e.g. cash, local government bonds) in a margin account. - The margin account will reflect a defined probability of loss in some defined period, typically one day. - Futures margin accounts require both parties to deposit a minimum required sum of money. This initial deposit is typically less than 10% of the actual futures price. - Since markets may move each day, the collateral in the margin account is adjusted each day in line with market movements. This process is called marking to market. - There is usually a minimum amount held in the margin account, known as the maintenance margin. - At maturity, the price of the futures contract must equal the cost to purchase identical goods in the market; otherwise, there would be an arbitrage opportunity that would disappear through the actions of investors. - The clearing house also may make margin calls during the day and not just at the end of the day if markets have extreme movements. - It is still possible for the clearing house to be exposed if markets move very rapidly and the losses exceed the margin balance of the party losing money. - If the party losing money were to default, then the clearing house provides a guarantee that it will cover the loss. - The clearing house does this through maintaining an insurance fund. - If the insurance fund were depleted, then the clearing house could raise a levy on all the remaining market participants, but this has never been required to date. - Existence of the clearing house allows traders to close out their positions by taking out a contract from the opposite perspective to the original contract. E.g. for a long trader, a contract can close out the contract by purchasing the corresponding short side of the contract. The exchange will recognise the trader has a net zero position and will not require both contracts to be fulfilled at maturity.

Describe and demonstrate an understanding of fundamental analysis, including key assumptions.

- Assumes that the intrinsic value of a security (true value that the market should recognise) can be calculated by the analysis of financial and accounting information published by companies, along with other public information that analysts can collect. - Analysis normally uses a discounted cash flow applied to fundamental variables relating to a security (such as dividends, earnings or free cash flow). The present value of these is the fundamental or intrinsic value of the security. - In practice, the aim is to ascertain if the current market price of a security is cheap or expensive relative to the intrinsic value, in order to buy cheap stocks and sell expensive ones, thereby generating an excess return when the market price converges to the intrinsic value as other investors catch up with the assessment made by the fundamental analyst. - Users of fundamental analysis believe they can beat the market by earning excess returns from investment decisions that are made earlier than other market participants. - The method often uses a discounted cash flow approach to valuation with the discounting process being applied to certain fundamental variables relating to a security such as the dividends, earning, or free cash flow. The present value of these is derived and described as the intrinsic value of the security. - Fundamental analysis is normally carried out for individual securities in a 'bottom-up approach' rather than forecasting returns at a market-wide level. - Users of fundamental analysis are sometimes known as value investors. Many institutional investors and fund managers have used fundamental analysis over the last 80 years.

Describe and demonstrate an understanding of Behavioural Finance, including key assumptions.

- Behavioural finance is not yet a cohesive theory or paradigm that fully describes how investment markets behave. - Nonetheless, behavioural finance studies have challenged the key assumptions of MPT as well as provided some support for the efficacy of both technical analysis and fundamental analysis as processes that assist in decisions that can lead to some excess returns. - Behavioural finance grew from a significant critique of Expected Utility Theory. - It is still at the stage of being a collection of challenges to MPT based on empirical observations of anomalies in investment market behaviour as evidenced by price movements. - If the assumptions of MPT are true, these anomalies should not exist. - The existence of the anomalies is necessary to challenge the MPT paradigm, but they are not yet sufficient to form a completely new paradigm about how investment markets behave. - Behavioural finance focuses on the behaviour of investors in an attempt to explain some of these anomalies. - These included assumptions about investors' attitudes to risk and return, which had been capable of being incorporated in mathematical formulae, but which were not borne out of practice. - The studies carried out by the behaviourists examined the behaviour of investors who were trying to make decisions under conditions of uncertainty. - The work done in behavioural finance was based on observation of behaviour rather than simplifying assumptions that were mathematically more tractable. - The anomalies and behaviours that have been observed in investment markets over the last 40 years include a range of phenomena that have formed the basis of studies in behavioural finance.

Explain what price limits are in futures contracts.

- Certain exchanges as well as futures contracts contain provisions that limit the daily price changes; these are called price limits. - Price limits establish a range relative to the previous day's settlement price within which the subsequent day's trades may occur. - If prices were to move outside this range, trading would be stopped. E.g. if prices moved above the upper price limit, then trading would cease but may recommence that day if the price subsequently falls within the day's range. Similarly, if price were to fall below the lower price range, trading would be halted but may recommence if prices rise into the daily allowable range. - The exchange has the right to expand the limits for the following day. - The price limits may restrict free-market movements but are designed to help manage the clearing house's credit exposure.

Describe and demonstrate an understanding of Modern Portfolio Theory, including key assumptions.

- Depends on two key assumptions: 1. There are sufficient investors who are rational maximisers of the expected utility of wealth to make the investment market rational. 2. All information is rapidly incorporated into prices so that the market is efficient (Efficient Market Hypothesis). - If EMH is true, fundamental analysis and technical analysis will not lead to higher returns or high returns per unit of volatility of returns for any security of portfolio of securities because all relevant information is already encapsulated in the price of the securities. - This means it is not possible to beat the market by making decisions that are made using fundamental or technical analysis. - MPT depends on Expected Utility Theory (EUT).

List the different possible asset liability matching strategies.

- Exact perfect match: timing and value of every liability cash flow has an exactly matching cashflow from the asset portfolio regardless of changing market conditions. - Exact replicating portfolio: assets are selected to deliver cashflows that replicate the liability cashflows exactly. - Approximate partial matching: assets selected to match the investment or economic characteristics (e.g. inflation) but unable to exactly match the potential cashflows of uncertain event (e.g. timing of death or financial cost of a cyclone). May require reserves, insurance or derivatives to ensure able to meet all possible liability cashflows in all market conditions and every event. - Approximate immunisation: select assets to ensure that the present value of the assets will increase or decrease exactly in line with the present value of the liabilities regardless of small changes in the interest rate of the portfolios, to ensure net position is unchanged. - Approximate replicating portfolio: tradable assets are selected to deliver cashflows that approximately replicate the liability cashflows, noting this will focus on economic factors. Asset values will not move in line with mortality, morbidity, lapse rates etc. Can use derivatives to match any financial guarantees arising from liabilities, although may be complex. - Intentionally not matching: Perhaps assets are chosen to exploit inefficient market pricing or due to risk-seeking behaviour, with no regard to liability cash flows. - Circumstantially not matching: in the specific circumstances it may not be possible to match so no attempt made.

Explain the characteristics of exchange-traded derivatives.

- Exchanges have strict rules and regulations to maintain trust and integrity in the system. - The exchange's clearinghouse novates the contract (i.e. replaces the original contract between the buyer and seller) and becomes the counterparty to both the buyer and the seller. This process guarantees both sides of the trade. The clearinghouse guarantees that the party making money will receive their payout regardless of whether the other party defaults, thus taking on the credit risk. This is important as by the time of settlement, one party to the trade would be losing money on the derivative contract while the other party would be making money. - Derivative contracts that are traded on exchanges are standardized. Specifically, the amounts for trading lots; expiry dates, and underlying instruments are specified. Such standardization supports the creation of liquidity and enables the market to be more efficient compared with having multiple expiration dates and varying trading sizes. Terms and conditions are specified by the exchange; limited customization options are available to investors.

Explain what open interest is in the context of futures contracts.

- For every type of futures contract traded on an exchange, there is a measure, known as the open interest, that notes how many long positions or short positions, but not both, there are in the futures contract. - When a futures contract is launched then, by definition, there are zero contracts at outset and then the open interest grows as more trades are entered, but the open interest must decrease at some point as the final position of maturity is zero open interest.

Hybrids

- Hybrid instruments extend existing fundamental features and instruments to form endless combinations with equities, debt securities, currencies etc. E.g. option and bond combined to form puttable, callable, or convertible bonds. - Similarly, swaps and options can be combined to form swaptions.

Explain Expected Utility Theory.

- In EUT, utility is defined as the satisfaction or benefit that an individual obtains from a course of action. - EUT assumes that a function, U(w), representing an investor's utility of wealth, w, at some future date can be described and that investors make decisions that will maximise the expected value of utility given their views about the probability of the different outcomes. - When this theory has been applied to investment it has been assumed that a numerical value called the utility can be assigned to each possible value of the investor's wealth by what is known as a utility or preference function, denoted U(w), so that utility is a function of the investor's wealth. The derivative of the utility function, denoted U'(w), is the rate of change of utility with respect to wealth. - Investors' preferences are assumed to be influenced by their attitude to risk, assuming also that investors will always prefer more wealth to less. Therefore EUT is assuming that U'(w) > 0 for all investors. - A risk-neutral investor is indifferent either to a fair gamble or the status quo so that the utility function U(w) is linear, U'(w) = c (a constant), and U''(w) = 0. - A risk-averse investor values an incremental increase in wealth less highly than an incremental decrease. In this case the second derivative U''(w) < 0 - that is, the rate of increase in utility declines as wealth increases and the utility function is concave. The risk-averse investor will reject a fair gamble that has the prospect but not the certainty of increasing wealth. The risk-averse investor would need to perceive a higher than expected probability of success to accept the gamble. - A risk-seeking investor values an incremental increase in wealth more highly than an incremental decrease such that U''(w) > 0 - that is, the rate of increase in utility increases as wealth increases and the utility function is convex. The risk-seeking investor will seek a fair gamble that has the prospect but not the certainty of increasing wealth. - EUT has limitations that reduce its usefulness for investment management. - One limitation is that to calculate expected utility, the precise form and shape of an investor's utility function needs to be known. This is difficult to obtain in practice in terms that are mathematically tractable. - Usually, only a broad description, such as the degree of risk aversion of the investor, can be used to identify likely responses to decision-making among available choices under conditions of uncertainty. - Alternative decision rules have been developed that can be used for risky choices. - These include mean-variance analysis. This related initially to the construction of portfolios that were efficient in terms of maximising returns per unit of risk where risk was defined as the volatility of returns. - The theory assumed that all investors were rational maximisers of expected utility, which was defined as the return per unit of volatility of return. - It was, therefore, dependent on the EUT developed by von Neumann and Morgenstern as a descriptor how investors actually behave. - In Markowitz's formulation, investors choose 'mean-variance-efficient' portfolios, which are defined as portfolios that: Minimise the variance of portfolio return, for a given expected return; or Maximise expected return, for a given variance. - Thus, the Markowitz approach is often called a mean-variance model, which optimises the portfolio asset allocation based on a trade-off between expected return of the portfolio and variance of the portfolio return at a given risk tolerance, defined as a desired level of volatility in the portfolio return. - Mean-variance optimisers are still used today by managers of multi-asset class portfolios. - An important strand of the development of MPT, as it related to how investment markets behave, was the work done on the behaviour of security prices. - Statistical independence over time of weekly returns from various stock indices has been documented. - It has been explained that such randomness in returns should be expected from a well-functioning stock market. - Key insight was that competition implies investing in stocks is a 'fair game', meaning that a trader cannot expect to beat the market without some informational advantage. - The essence of the 'fair game' is that the current stock price reflects the expectations of investors, given all the available information. - Therefore, the price should only change if investors' expectations of future events change, and such changes should be randomly positive or negative as long as investors' expectations are unbiased. - It was later recognised that the 'fair game' model allows for the expectation of a positive price change, which is necessary to compensate risk-averse investors.

Discuss the critiques of Modern Portfolio Theory.

- Modern Portfolio Theory depends on Expected Utility Theory. - EUT has been criticised due to how it characterises investor preferences. For example, it was argued that an individual can have different utility functions (i.e. different attitudes to risk) that depend on the context or framing of the decision. - The framing effect is a cognitive bias where people decide on options based on whether the options are presented with positive or negative connotations (e.g. as a loss or a gain). - This observation was motivated by the evidence that the same individuals will both buy insurance (risk-averse) and gamble (risk-seeking) in different contexts. The debate on the validity of EMH has mainly focused on the semi-strong form with tests being in two categories: 1. Informational efficiency tests; and 2. Volatility tests. - The EMH states that asset prices reflect information, but it does not explicitly tell us how new information affects prices. - It is also difficult to establish when information arrives in practice as many events that may affect prices are rumoured prior to announcement. - There have been studies that have shown the market overreacts to some events and underreacts to other events. - If the overreaction or underreaction is corrected over a subsequent period, then investors could take advantage of the correction and earn excess returns as the market price converges to an intrinsic price or reverts to a mean price. - This would be a challenge to the validity of the EMH. - Studies that have found evidence of overreaction to events have demonstrated the following effects: 1. Markets appear to overreact to past price performance of securities whereby those with strongly increasing prices continue to rise - a feature used in technical analysis. 2. Companies with high earnings to price, cash flow to price, or net tangible assets per share to price tend to have high future returns - demonstrating an excess return based on analysis, as claimed in fundamental analysis 3. Evidence for mean reversion Resistance to the view that stock prices systematically overreact, as well as to the behavioural interpretation of this evidence, came from two sources. First, Fama and French found that stocks earn larger returns during more difficult economic conditions when capital is scarce and the default-risk premiums in interest rates are high. Higher interest rates initially drive prices down, but eventually prices recover with improved business conditions, and hence the mean-reverting pattern in aggregate returns. Second, supporters of the EMH argued that the cognitive failures of certain individuals would have little influence on stock markets because mispriced stocks should attract rational investors who buy under-priced and sell overpriced stocks. Studies have also found evidence of underreaction to events such as the following effects: - Stock prices continuing to respond to earnings announcements over periods of up to a year after their announcement, which suggests a slow response to new information; - Excess returns for both the parent and subsidiary firms following a de-merger over a protracted period as the market is slow to recognise the benefits of the event; and - Lower returns following mergers where the market appears to initially overestimate the benefits from mergers and the stock price subsequently slowly reacts negatively as the optimistic view is proved to be wrong. All these effects have often been referred to as 'anomalies' within the EMH framework as they ought not occur if the market is incorporating new information rapidly into prices. Research in the field of behavioural finance investigated whether such anomalies arose due to the behaviour of individual investors departing from that predicted by models based on rational expectations. These apparent inefficiencies led behavioural finance supporters to cite evidence from psychology that people tend to make systematic cognitive errors when forming expectations. One such error that may explain overreaction in stock prices is the representative heuristic, which holds that individuals attempt to identify trends even where there are none and this can lead to the mistaken belief that future patterns will resemble those of the recent past. On the other hand, momentum in stock returns may be explained by anchoring, the tendency to overweight initial beliefs and underweight the relevance of new information. Momentum observed over intermediate horizons may be extrapolated over longer time horizons until overreaction develops. This observation is difficult to apply to an investment strategy, because the point where momentum stops, and overreaction starts, is difficult to perceive except after the fact. It has also been noted that: - Some of the reported effects do not appear to persist over prolonged periods and so may not represent exploitable opportunities to make excess returns - that is, the effects are a challenge to the EMH (in the absence of transaction costs) but cannot be profitably used in practice where fast/frequent transactions are required and there are associated costs. - Some anomalies relate to strategies that are higher risk than the market average and once these higher risks have been taken into account, many studies that claim to show evidence of inefficiency are compatible with the EMH.

Explain the characteristics of OTC derivatives.

- OTC derivative markets represent the entire derivative market outside of the exchange-traded markets. - Investors can create, customise, and trade almost any type of derivative that is legal. - OTC markets involve trading directly between the two parties without the need for a clearinghouse. - OTC markets also have rules and regulations, but these can vary in their level of sophistication as well as the extent of implementation. - Since the GFC, new regulations have been introduced by various countries that have reformed OTC markets to conform to exchange-traded derivative market practices, the rationale being that the OTC market could lead to significant systemic risk due to its large size, and increased transparency would lead to more robust and resilient markets. As a result, some OTC derivative trades now need to be cleared through a central clearinghouse and trades need to be reported to regulators.

Discuss the critiques of Behavioural Finance.

- One of the major criticisms of behavioural finance is that by choosing which bias to emphasise, one can predict either underreaction or overreaction in market prices. - In other words, one can find a story that fits the facts and appears to explain some puzzling phenomenon. - Findings of behavioural finance in terms of how they amount to criticisms of the EMH. Patterns of possible predictability suggested by studies of the behaviour of past stock prices. They include: 1. Short-term momentum and underreaction to new information; and 2. Long-run reversals

Explain what an option premium is.

- Option buyer pays the writer (seller) of the option a premium because the writer has given the option holder a right to exercise when it is favourable to do so without the obligation when it is not. - Premium represents a fair price and reflects the value of the option at commencement. - Premium is calculated as the present value of the cash flows together with their likelihood of occurring. - Option premiums can erode the value of a portfolio if they are not done with care and rigour.

Distinguish between exchange-traded derivatives and over-the-counter derivatives.

- Standardisation: Exchange-traded derivatives are characterised by having standardised contract terms for derivative expiry dates, trading lots/amounts, and underlying assets. OTC derivatives, on the other hand, are fully customisable. - Rules and regulations: Exchanges have strict rules and regulations to maintain trust and integrity in the system. Over-the-counter (OTC) markets also have rules and more recently regulations, but these can vary in their level of sophistication as well as the extent of implementation. The extent of OTC regulation is significantly less than exchange-traded markets. - The clearinghouse: The exchange's clearing house novates the contract (i.e. replaces the original contract between the buyer and seller) and becomes the counterparty to both the buyer and the seller. This process guarantees both sides of the trade. On the other hand, OTC markets involve trading directly between the two parties without the need for a clearing house. - OTC markets are expected to remain more flexible and continue to have some level of privacy compared to exchange-traded derivative markets.

Discuss the critiques of technical analysis.

- Studies that have tested the efficacy of technical analysis have focused on how well past prices and volumes explain future price movements. - The evidence about technical analysis is not completely conclusive, although it suggests that it has some limited predictive power. - Some studies report significant excess returns when technical trading rules are used. - Other studies conclude that technical rules do not earn excess profits over a simple buy-and-hold strategy. - Original empirical work supporting the notion of randomness in stock prices supported the view that the stock market has no memory, i.e. did not support technical analysis. - Other studies found that short-run serial correlations were not zero and that there does seem to be some momentum in short-run stock prices. - Through the use of sophisticated nonparametric statistical techniques that can recognise patterns, some of the stock price signals used by technical analysts may actually have some modest predictive power. - Although the empirical evidence suggests that technical analysis has limited predictive power, it is still used by many investors even if only as an adjunct to other forms of analysis. - In recent years, there has been significant development of high-speed and high-frequency trading techniques and processes that seek to make use of improvements in the speed and capacity of computing and communication technology together with mathematically derived algorithms to plan and execute investment strategies that make money by identifying and exploiting price anomalies faster than competitors. - The volume of such trading is sufficient to attract the attention of securities market regulators who are concerned about the stability of the investment markets.

Describe and demonstrate an understanding of technical analysis, including key assumptions.

- Technical analysis seeks to identify recurring patterns in historical prices to forecast future price trends. - Key assumption is that patterns in price and volume within an investment market can be perceived, analysed, and used to forecast future prices in the market. - Relies on the idea that prices 'move in trends which are determined by the changing attitudes of investors toward a variety of economic, monetary, political and psychological forces'. - Assumes that these trends are therefore predictable to some extent, through the analysis of past prices and volumes. - The price and volume data that are analysed are often displayed in various types of charts. The charts and analyses are used to forecast future movements in the price of individual securities or entire investment markets described by indices. - This analysis is often further developed into trading rules, which inform investment strategy. Some of the simpler rules include: Filter rules - buy when the price rises by a given proportion above a recent trough; Trading range breaks - buy when the price rises by a given proportion above a recently established trading range; and Moving average intersections - buy when a shorter moving average penetrates a longer moving average from below. - In practice, analysts choose the time horizon over which troughs and peaks are to be identified and moving averages calculated, as well as the threshold at which a decision is made. This can make the efficacy of the process hard to evaluate. - Most of these technical trading rules are simple and inexpensive to implement. This will make them widely available to many investors. - They would, therefore, not be expected to generate excess profits if the investment market is efficient.

Explain the Efficient Market Hypothesis, including its assumptions and various forms.

- The concept of an efficient investment market was initially defined as a market that 'adjusts rapidly to new information'. - This implies that the market processes information rationally, in the sense that relevant information is not ignored. - As a consequence, extra returns cannot be earned from fundamental analysis or technical analysis. Three forms: 1. Weak - the market price of an investment incorporates all information contained in the price history of that investment. Knowledge of an investment's price history cannot produce excess performance as this information is already incorporated in the market price. This form, if true, means that technical analysis will not produce excess returns. 2. Semi-strong - states that the market price of an investment incorporates all publicly available information. Knowledge of any public information cannot produce excess performance, as this information is already incorporated in the market price. This form, if true, means that fundamental analysis will not produce excess returns. There is a cost involved in obtaining and using even publicly available information. Any advantage achieved by acting on price-relevant information could well be eroded by the cost of obtaining and analysing that information. 3. Strong - states that the market price of an investment incorporates all information, both publicly available and that available only privately or to insiders. Knowledge available only to insiders cannot produce excess returns, as this information is already incorporated in market prices. - An extremely high level of market efficiency would preclude the profitable opportunities necessary to motivate the very security analysis required to produce information. - Market frictions, including the costs of security analysis and trading, limit market efficiency. - The level of efficiency differs across markets, depending on the costs of analysis and trading. For example, weak-form efficiency allows for profitable fundamental analysis. Assumptions: - Market prices already incorporate relevant information because active trading by even a small number of informed investors can lead to market prices that fully reflect all information available - Competition between investors seeking abnormal profits drives prices to their 'correct' value - a similar concept to intrinsic value in fundamental analysis. The EMH does NOT assume that: - All investors are rational, but it does assume that there are enough rational investors so that investment markets as a whole are rational; - Markets can foresee the future, but it does assume that markets make unbiased forecasts of the future based on all known information that is incorporated into prices. - The EMH also allows that forecasts may change significantly over short periods as new information is rapidly incorporated into prices, such as in stock market falls.

Discuss the critiques of fundamental analysis.

- The studies that have been done on the efficacy of fundamental analysis have often included tests of how well the analysis predicts future prices. - There have also been studies of excess returns earned by fund managers that have used fundamental analysis. A number of these studies were carried out in the context of examining whether investment markets are efficient or whether it is possible to exploit inefficiencies in order to earn excess returns - beat the market - using processes such as fundamental analysis. - Analysis of the published results of fund managers using fundamental analysis have indicated that often they did not perform any better than simply buy-and-hold strategies. - Attempts to explain the tendency for the method not to add value during some periods gave rise to the EMH, which became part of the development of MPT. - EMH claims that market prices already incorporate all the relevant information via a process that involves the transactions in securities by some but not all investors. - It is claimed that the active trading patterns of a small number of investors using fundamental analysis can lead to accurate market prices that equate to intrinsic value, and so the effort of using fundamental analysis in pursuit of excess returns is mainly of no value.

Discuss the validity of the EMH.

- The validity of the EMH has been tested by numerous studies and conclusions have been drawn both in support of its validity and against it. - One possible explanation of the differences in outcomes is that many published tests make implicit and explicit, but possibly invalid, assumptions - for example, normality of returns, or stationarity of time series. - Some of the differences in conclusions may relate to the cost of implementing strategies. For example, does the presence of persistent anomalies in prices disprove the EMH if transaction costs prevent the use of the anomalies to make money? - There is also the need to make an appropriate allowance for the risk being tolerated when implementing an investment strategy. - A strategy that produces higher returns than the market portfolio by taking higher risks does not necessarily invalidate the EMH. - An investment strategy that produces returns above the level necessary to fairly compensate for the risk being tolerated would challenge the validity of the EMH. - There has, however, been a divergence in the definition of risk, which has contributed to the scope for obfuscation on the validity of the EMH.

Explain the Equity Premium Puzzle.

- This puzzle is related to the gap in returns from risk-bearing stocks when compared with the returns earned from lower-risk government bonds. - An explanation for the observed equity premium is that it reflects the difference in the level of risk associated with stocks relative to bonds and bills. - Higher-risk securities require higher returns to attract investors. - The puzzle is that the equity premium levels observed in the data seem too large to be explained solely via risk-aversion using the capital asset pricing model (CAPM), which is typically used in financial economics. - One significant explanation is that myopic loss aversion can be used to explain the abnormally large discrepancy in returns across stocks and bonds. Myopic loss aversion suggests that investors are less risk-averse when faced with a multi-period series of 'gambles', and that the frequency of choice or length of reporting period will also be influential. - This is because investors are more concerned by losses than they are pleased with gains of an equivalent size. - This leads investors to focus on very short-term returns and volatility rather than long-run earnings. - Since stock prices are typically more volatile in the short run, this may dissuade myopic investors from buying stocks unless the return premium on the stocks is sufficiently high to compensate for this loss aversion. - Thus, the substantial equity premia observed in the data across the world are so high because they take into account both risk-aversion and this aversion to short-term losses. - The observed past equity premium is therefore consistent with loss aversion, and an assumption that people evaluate their portfolios based on the last 12 months of returns (myopic), rather than over longer timescales.

Describe the implications of market efficiency.

- Whether or not markets are efficient has important implications for investors including fund managers. - If markets are inefficient, we should expect active investors with above-average skill and resources to perform better than passive managers who seek to match a (usually capitalisation weighted) market index. - However, the performance of investors should be considered net of various fees and transaction costs (e.g. brokerage, market impact). - To demonstrate an exploitable opportunity in the market, the opportunity should be sufficiently large to remain intact even after all these costs are taken into account.

Describe the concept of asset liability matching.

A company's or fund's primary objective is to meet liabilities as they fall due. An entity may choose to reduce the risk of failure due to investment risk by adopting a matched ALM strategy. Entities reduce investment risk using strategies including matching of assets to liabilities, approximate matching or replicating portfolios. It may also choose to deliberately mismatch, where allowable, to maximise return on investments. ALM strategies that seek to match assets to liabilities are either an exact match or an approximate match to the needs of the investor.

Explain the factors affecting investment strategy.

A list of the major factors that affect investment strategy include: - the needs of the investor — liability consideration (nature, term, currency and uncertainty both in timing and amount), regulatory, legal or any other restrictions imposed, solvency and liquidity requirements, and the - risk appetite; - the stated investment objective(s); - investment philosophy; - the required rates of returns as well as the expected returns for the investment universe available; - tax considerations and implications; - peer relative strategies; and - the current portfolio, both in terms of what it is invested in as well as its size relative to the liabilities.

Explain the concept of replicating portfolios. For what kind of products are the replicating portfolios identical to the actual assets? For what businesses are the replicating portfolios more problematic?

A replicating portfolio is a portfolio of assets that have been constructed so that the cash flows arising from the assets closely match the cash flows arising from the liabilities. Replicating portfolios may provide exact or approximate matching. The present value of those asset cashflows is targeting to be close to the PV of the liability cashflows. The goal is that the asset portfolio PV moves in line with the liability portfolio PV when there are financial or economic factors changing, e.g cash rates. A replicating portfolio is not expected to move with liabilities for non-economic factors such as mortality, morbidity, and lapses. Such changes cannot usually be matched. Liabilities that are exposed only to financial factors can therefore be replicated exactly (e.g defined contribution superannuation accounts) or approximately (e.g investment bond with guaranteed minimum return). For products with exposure to financial market risks, such as investment-linked business and DC funds where there is a direct link between assets and liabilities, the replicating portfolio is identical to the actual assets. Typically, there is no mismatch with death or surrender as the assets are marked to market each day. The situation is different if there are investment guarantees. In many jurisdictions, participating business policyholders are usually allocated a minimum proportion of the profits—e.g. 80% in Australia. However, there is a minimum investment return implied by the guarantees of sums insured and reversionary bonuses or investment account balances. For this business, the replicating portfolio is more problematic as it will depend on the maturity of the fund. There is a considerable amount of work involved in deriving replicating portfolios for business with complex financial guarantees. The use of replicating portfolios expands the range of matching asset portfolios that can be constructed. It also expands the range of asset types that can be included in a matching portfolio, for example, using put options to limit downside risks. However, there is no guarantee that a replicating portfolio can always be constructed. For example, long- term fixed interest assets suitable for backing long-term products such as annuities are difficult to find. As another example, options are not normally available for property investments. Replicating portfolios, whether actual or hypothetical, can form part of an analysis and attribution of surplus. Expected returns on the replicating portfolio can be used as a liability-driven benchmark.

Briefly explain how approximate matching can be utilised when matching liability options which may not be exercised until many years into the future.

A similar but more difficult problem arises with matching liability options, which may not be exercised until many years into the future. For example, a retirement product or deferred retirement benefit might include an option to convert a lump sum to an annuity or pension at age 65 at guaranteed rates. The company or fund will not know, in advance, what proportion of its policyholders or members will take this option. In this case, an approximate matching strategy will require an estimation of the future take-up rate of such options.

What is an alternative approach to immunisation? What are the advantages and disadvantages of this alternative?

An alternative approach to immunisation, while obtaining a similar result, is to build a stochastic model of the term structure and perform simulations. This has the following advantages: - real-world features can be included, which could not in an analytical approach; and - the volatility of interest rates with different terms to maturity can be modelled. The disadvantages are: - the conclusions are dependent on the stochastic interest rate model chosen, as well as any features about the liability cash flows that are assumed; and - sampling variability is introduced.

Describe what an asset liability model is.

An asset liability model is a model that projects and compares assets and liabilities. The model should show the mismatching between both amounts and timing of asset and liability proceeds. There is no agreed way to project the cash flows. Projection models may be deterministic, with suitable stress and scenario testing. Alternatively, the projections may involve stochastic elements, particularly on the asset side.

Explain the concept of approximate matching.

Approximate matching consists of selecting assets that behave in a way that is consistent with the fund's liabilities - value linked to inflation over time or generate cashflows at the times required to offset the liability cashflows, etc. term-90 For many policy and fund types, a limiting issue in following a matching strategy is the availability of assets with matching terms and profiles and suitable investment returns. Alternative strategies with approximate or partial matching may be followed, particularly where benefit amounts have greater uncertainty. More complex and longer-term liabilities can be more difficult to match.

Define and describe Asset Liability Management.

Asset liability management (ALM) is the process of managing risks due to mismatches between an insurer's or fund's assets and liabilities. It includes the selection, implementation and ongoing management of the fund's or company's investment strategy. ALM addresses a wide range of risks such as interest rate and liquidity risk, as well as business and regulatory risk.

Explain the significance of asset liquidity and divisibility and trading costs when selecting an investment strategy.

Asset liquidity is an important consideration when policy payments are subject to large, short-term fluctuations. A liquid asset is an asset that can be sold readily without undue negative impact on its sale price. Cash in the bank is the most liquid type of asset. At the other end of the spectrum, assets such as interests in venture capital holdings and direct property are normally illiquid. The divisibility of asset holdings and trading costs also need to be considered as part of selecting a strategy. For example, direct property is likely to be held or sold in its entirety, as opposed to listed equity that can be sold in smaller parcels. Transaction costs on the purchase or sale of direct property are likely to be significant, making this generally an unsuitable asset class for short-term investments.

Explain the six types of biases.

Biases are tendencies to deviate from rationally assessed outcomes and have been well documented by psychologists over the last 40 years. Six types of bias: 1. Overconfidence bias - occurs when people systematically overestimate their own capabilities and judgment. Moreover, studies show that the discrepancy between accuracy and overconfidence increases, in all but the simplest tasks, as the respondent becomes more knowledgeable. Accuracy increases to a modest degree, but confidence increases to a much larger degree. This may, in turn, be a results of hindsight bias and confirmation bias. 2. Hindsight bias - events that happen will be thought of as having been predictable prior to the event and events that do not happen will be thought of as having been unlikely prior to the event. 3. Confirmation bias - people will tend to look for evidence that confirms their point of view and will tend to dismiss evidence that does not justify it. 4. Self-serving bias - occurs when people credit favourable or positive outcomes to their own capabilities or skills, while blaming external forces or others for any negative outcomes. This may be done to maintain a positive self-image and avoid cognitive dissonance, which is the discomfort felt when there is a discrepancy between the perceived self and the actual self - as evidenced by outcomes. This type of behaviour is observed in investors when assessing their returns from investment. 5. Status quo bias - the inherent tendency of people to stick with their current situation, even in the presence of more favourable alternative and even when no transaction costs are involved. 6. Conservatism bias - when things change, people tend to be slow to pick up on the changes and continue to maintain the status quo regardless of those changes. This conservatism bias is at odds with the representativeness heuristic (fast decisions based on limited information). When conditions change, people might initially underreact because of the conservatism bias. Eventually, if there is a long enough accumulated pattern of changed conditions that is at odds with their previous view, they may adjust to it and possibly then overreact, or react too late.

Discuss the risk and return characteristics of conventional government bonds (use SYSTEM T).

Conventional government bonds recap: Security — The closest to being risk-free for developed countries and where the government is highly rated. Yields — Income streams from these bonds are fixed (or indexed) and capital gains are nil if the bonds are held to maturity. Yields — real versus nominal. If the bonds are held to maturity, then the expected nominal return is known in advance. However, uncertainty remains for the following reasons: • reinvestment of coupons will be at an unknown rate, unless they are used to meet liabilities as and when they are received; • if the bonds are sold before maturity, the yield achieved will not be known in advance; and • real yields depend on future inflation and as this is unknown in advance the real yield will be unknown in advance. Yield — relative return. The lower risk implies a lower return; however, this ignores inflation risk. When inflation is uncertain or high, history suggests higher nominal returns. Over long periods, returns are generally lower than equities. Spread — volatility of capital values. Changes in supply or demand will affect market values; however, volatility tends to be much lower compared with equities. Term • Short-dated (less than 5 years) • Medium-dated (5-15 years) • Long-dated (> 15 years) • Undated (i.e. irredeemable) Expenses — Transaction costs are relatively low compared with other asset classes due to high levels of liquidity and marketability. Marketability — Marketability is usually very good with relatively large quantities transacted with little impact on price. Low dealing costs, large quotation sizes, a developed derivatives market, and the STRIPS market all assist with marketability. Tax — Tax treatment varies between countries and is country-specific.

Discuss the risk and return characteristics of corporate bonds (use SYSTEM T).

Corporate bonds have generally the same characteristics as government bonds, with the exception that they have: - generally, lower levels of security, the extent of which will depend on the issuer; - lower marketability as issue size tends to be significantly lower; and - higher yields to allow for marketability and default risk.

Explain whether or not customisation through the OTC derivative market leads to lower levels of liquidity.

Customisation through the OTC market does not necessarily lead to less liquidity. OTC derivatives can be created and subsequently offset by entering into the direct opposite trade, sometimes even with the same party. Liquidity will always be driven by supply and demand (i.e. trading interest), which can be high or low in either the exchange-traded market or the OTC market. For example, some exchange-traded derivatives have very low liquidity due to having very low trading interest.

Discuss the storage of derivatives.

Derivatives were originally used to trade commodities, such as farmers agreeing on a price to sell their crops. The underlying assets for these derivative contracts, such as grain and corn, can be stored for a reasonable amount of time. Storage incurs costs and therefore need to be allowed for when valuing derivative. For some assets, such as precious metals, storage can continue indefinitely. Equities and currencies also share this perpetual storage characteristic, whereas other fixed-term assets such as bonds have a storage term until maturity. Commodity storage can be quite expensive compared to financial asset storage, which can be done relatively inexpensively via a custodian. Certain assets generate returns while being stored, such as equity dividends and bond coupon payments. The net effect of storage costs and returns earned while being stored influence the valuation of a derivative. All the basic derivatives covered in this module (forwards, futures, swaps, options) are priced and valued using the same principles. Therefore, they require the ability to account for storage costs or holding the underlying asset. It is worth noting that some underlying assets are not storable, such as weather events, and so derivatives based on these types of underlying events need to reflect in their valuations the extent to which certain aspects are possible or not.

Explain how derivatives are priced.

Determining the value of a derivative is very similar to determining the value of the underlying asset. Valuations are based on the present value of future cash flows, with these calculations reflecting the inherent risk, opportunity cost, and likelihood of receiving the cash flows. Derivatives apply the same principles to valuations, but specifically consider the potential movement in the underlying asset as it derives its value directly from it. As the value of the underlying asset will reflect the present value of future cash flows, special care needs to be taken to ensure there is no double counting of the risk components when deriving the values of the derivatives. Derivative values are calculated by constructing a hypothetical portfolio consisting of derivatives and the underlying assets, which results in a hedged portfolio and therefore eliminates risk. As such, the hedged portfolio should earn the risk-free rate. A derivative's value can then be solved as the price that would force the hedged portfolio to earn the risk-free rate. Derivative valuations rely on the investor's ability to store (or hold) the underlying asset.

Describe the fair value approach to the valuation of assets.

Fair value is defined here as the price that would be paid by a willing buyer to a willing seller. A more technical definition from the international accounting standards states that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The following elements capture the concept of fair value: - Market: When measuring fair value, account needs to be taken of the characteristics of the asset or liability in the same way that market participants would take those characteristics into account. Characteristics might include the condition and location of the asset and any restrictions on the sale or use of the asset. - Price: A fair value measurement assumes that, in pricing the transaction, market participants act in their economic best interest. - Orderly: Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction, regardless of whether that price is directly observable or estimated using another valuation technique. Fair value is determined after spending the transaction costs incurred in purchasing the assets but before any transaction costs are incurred on sale. This means that any buying costs are recognised in the profit and loss statement during the reporting period in which an asset is purchased and any selling costs are recognised during the reporting period in which an asset is sold. A drawback of this method is that fair value overstates the amount a company or fund would receive if it sold all its assets (because part of the proceeds would go to paying the selling costs). The best evidence of fair value is quoted prices in an active market (i.e. a market where the asset is traded in high volumes). For example, the fair value of listed equities can readily be determined from the latest market prices. For listed assets, fair value is normally determined as the price at the last sale, provided this lies within the bid and asking prices. The bid price is the highest price at which buyers are offering to purchase the asset. The asking price is the lowest price at which existing owners are willing to sell the asset. The asking price is usually greater than or equal to the bid price. Again, fair value can overstate the amount a company or fund will receive if it sold all its assets, as the amount of assets buyers are willing to purchase at a particular price could be smaller than the company's or fund's holding of the asset. The requirement that fair value is based on prices agreed between knowledgeable, willing parties means that actual transaction prices may sometimes be ignored. For example, in a mortgagee sale, a house owner is forced to sell their house as they are unable to meet their loan repayments to the bank. In this situation, the house owner or bank may need to sell the house quickly, regardless of the price they can receive for it. The selling price may, therefore, be less than fair value. Alternatively, an eager but unknowledgeable buyer may pay a price for an asset that exceeds its fair value. If a particular asset market is not active (i.e. the market doesn't experience a high volume of trading), fair value must be determined using a different valuation technique. In this case, the objective is to establish what the transaction price would have been on the measurement date in an arm's length exchange motivated by normal business considerations. Such fair valuations include consideration of one or more of the following: - recent arm's length market transactions between knowledgeable, willing parties for identical assets; - fair values at the reporting date of other assets that are substantially the same; - discounted cash flow analysis; and - option pricing models. If there is a valuation technique commonly used by market participants to price an asset and that technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, the company or fund should use that technique. Valuation techniques should make the maximum use of market inputs and rely as little as possible on company-specific inputs. They should incorporate all factors that market participants would consider in setting a price and be consistent with accepted economic methodologies for pricing financial instruments. For example, unlisted property assets may be valued by reference to recent transactions for similar properties. Actuaries need to understand how valuation techniques have been used by the life company or retirement fund to come up with a fair value. This will help to determine how reliable the valuation is and whether any adjustments need to be made for unreliable estimates. Fair value can become particularly difficult to determine at times of extreme market volatility or if there have been no recent transactions for similar assets.

List the 5 questions that are useful when reviewing a set of objectives.

Ferris set out five questions that are useful when reviewing a set of objectives: 1. Do they meet all legal agreements as well as the basic requirements of the investor? 2. Are there any special characteristics that need to be considered such as promises made in promotional literature? 3. Are they realistic? 4. If there is more than one objective, then are they consistent? 5. Are they clear and can they be explained and justified simply?

Explain the implications of arbitrage.

For efficient markets, which tend to have a free flow of information and low associated transaction costs, we expect two sets of cash flows that are identical to have the same price. Therefore, an asset would be expected to have only a single price or value. If it did not, then an investor could buy the cheaper one and sell the more expensive one without taking on any risk, thereby earning a profit in excess of the risk-free rate. This would result in an increased demand for the cheaper asset and a sell-off in the more expensive asset, forcing the prices to converge. Arbitrage is, therefore, referred to as the law of one price. In order to exploit such mispricing, an investor would need to have the ability to short sell the expensive asset. Arbitrage elimination does not occur in every market as information may not be freely distributed and so the arbitrage opportunities might not be known by market participants. Also, if transaction costs were prohibitively high, then transacting the underlying asset might erode any potential arbitrage opportunities and deter investors from trading the mispriced securities. Arbitrage provides a relative value and not an absolute value. This is important as arbitrage provides a value relative to the value of other assets and does not base its valuation on any specific methodology, such as a discounted cash flow valuation model. Put-call parity is a specific application of the no-arbitrage assumption to option pricing. It defines the relationship between put and call prices on the same underlying asset, expiry dates, and strike prices. Put-call parity states that holding a call with an amount of cash equal to the discounted value of the strike is equivalent to holding the underlying share together with a put option on the share with the same strike price and expiry date as the call. This assumes that cash earns the risk-free rate and that the share is non-dividend paying. Put-call parity illustrates the relationship between European put and call options that have the same underlying asset, expiration, and strike prices. Put-call parity implies that the price of a call option informs a fair price for the corresponding put option with the same strike price and expiration and vice versa. When the prices of put and call options do not conform to this relationship, then an arbitrage opportunity exists, enabling investors to earn a risk-free profit until the prices converge to what is required to maintain the put-call parity relationship.

Explain how approximate matching is utilised for lifetime annuities and disability claims.

For lifetime annuities and disability claims in payment, expected payment terms can exceed 30 years. Current instalments of claim payments will be known but the amount and duration of future payments are uncertain. This uncertainty arises both from the underlying survival distributions and inflationary indexation of benefits. Inflation-linked investments, such as indexed bonds, may provide an acceptable matching asset profile, assuming the duration of policy payments is close to expected. However, these investments can be difficult to source in the required quantity and may provide poor investment yields.

Explain how approximate matching is utilised for participating business policies. Note that for participating business, bonus mechanisms provide a means of sharing investment gains and losses. Also note that as policies approach maturity, the proportion of total benefits subject to guarantee increases.

For participating business, bonus mechanisms provide a means of sharing investment gains and losses. Asset strategies with larger proportions invested in growth assets such as equity and property may be better matched to these liabilities. Expected returns from these growth assets support higher bonus rates in the longer term, in line with policyholder expectations. However, the basic benefits and certain types of credited bonuses provided under participating policies are guaranteed. Therefore, the investment strategy must take into account the nature of the guarantees on different elements of the policy benefits. As policies approach maturity, the proportion of total benefits subject to guarantee increases. A matching strategy for a more mature portfolio will include a substantially greater proportion of higher quality, fixed interest assets matched to the guaranteed payments.

Explain the other types of phenomena observed by behavioural finance.

Framing - the notion that how a concept is presented to individuals matters. For example, cognitive psychologists have documented that doctors make different recommendations if they see evidence that is presented as survival probabilities rather than mortality rates, even though survival probabilities plus mortality rates adds up to 100%. Underreaction - this means doing nothing when you should be doing something. In investments, when investors make no changes to their investment views despite new relevant information. It may be investors exhibit a confirmation bias by assigning more importance to information that confirms, or lends support to, their prior view, and down-weights contradictory information. This is related to the anchoring heuristic and being unduly influenced by their starting point and not updating their views enough in the light of new evidence. Similarly, an overconfidence bias also contributes to a tendency to underreact. Disposition effect - refers to the pattern that people avoid realising losses on securities that have fallen in price and realise gains on securities that have risen in price without reconsidering their relative prospects, which would require System 2 thinking. Herd behaviour - the tendency of people to follow or mimic the actions and decisions taken by others, as a mechanism to deal with uncertain situations. The underlying rationale may be that others must know better - safety in numbers - or that there is a desire to conform or belong to a crowd and not be isolated. Herd behaviour has been used to explain several investment market phenomena such as so-called stock market bubbles.

Explain what free assets are.

Free assets, or a surplus of assets compared to liabilities, allows the investor to move away from perfectly matched strategies to increase the total return on its investments. The justification behind such an approach would be: - creating higher benefits—such as for discretionary payments or participating products; - lower premiums or contributions—or even contribution holidays for DB fund sponsors; and - higher dividends—if there are any shareholders. The move could be by restructuring the strategy of the portfolio as a whole, or by establishing a separate investment strategy for the free assets.

Explain how basis risk can be introduced in futures contracts.

Future markets provide an investor with the ability to use the futures for hedging or speculative purposes. With the standardisation of contracts, it sometimes becomes challenging to find a futures contract with the exact same underlying asset the investor would like to hedge. If these are different, it introduces basis risk, which is the risk that the movement in the underlying asset for the futures contract does not exactly match the movement in the asset that the investor wants to hedge. Thus, basis risk introduces residual exposure.

Explain what is meant by the terms 'in the money', 'out of the money', and 'at the money' in the context of put options.

If S_T < X, the put is in the money. If S_T = X, the put is at the money If S_T > X, the put is out of the money.

Explain what is meant by the terms 'in the money', 'out of the money', and 'at the money' in the context of call options.

If the value of the underlying asset is greater than the strike price, then the option is in the money. If the value of the underlying is less than the strike price, then the option is out of the money. If the value of the underlying is equal to the strike price, then the option is at the money.

Explain why investors choose to purchase options rather than simply buying/selling the underlying asset.

Investors choose to purchase options rather than simply buying/selling the underlying asset because options provide a non-linear payoff that allows an investor to gain exposure without transacting in the underlying asset. Therefore, if markets were to remain flat or fall, the call would just expire worthless. Similarly, if markets were to rise, the put holder would still participate in the upside potential of the underlying asset as they did not sell out of their existing position.

Which of the four major investment market theories should investment practitioners use?

It is still open to investment practitioners to use any of the four major theories to assist them in their work of deciding under conditions of investment market uncertainty.

Explains the different risks that are faced in insurance/investments.

Life insurance and general insurance contracts involve the transfer of risk from one party. Different risks may be grouped under these broad headings: 1. Insurance risk - Risks taken on through contracts or obligations to provide future benefits to policy owners, retirement fund members, and other beneficiaries. Risks are managed through the process of underwriting, claims management, reinsurance and derivatives. 2. Market risk - relates to exposure from movement in financial variables, including effects of asset-liability mismatching 3. Credit risk - The risk of default or change in credit quality of issuers of securities, counterparties, and intermediaries. 4. Liquidity risk - There are a variety of different liquidity risks and the one considered briefly here is the risk of having insufficient liquid assets to meet obligations as they fall due. This is not usually an issue for insurance companies. However, there may be events that require immediate access to cash. Many insurance companies manage this risk by holding sufficiently liquid assets such as government bonds. Alternatively, they can negotiate an OTC option to borrow from a financial institution at a defined rate if a defined event occurs. Derivatives can help institutions to diversify their risk portfolio and reduce volatility in earnings. The uses of derivatives require prudent management and may be subject to stringent local regulations. Boards will define their risk appetite in respect of the use of derivatives.

Describe the main market participants in exchange-traded derivative markets.

Main market participants on exchange-traded derivative markets are: 1. Market makers (dealers) - guarantee to make a market, i.e. they stand ready to buy (at the bid price) and sell (at the ask price), regardless of whether there are any other investors willing to trade. Usually, the ask price is higher than the bid price creating what is known as the bid-ask spread. Standardisation enables market makers to often buy and sell at the same time and profit from the bid-ask spread. However, if they are unable to find another party to trade, they are forced to hold the open position and are exposed to the risk of adverse price movements in the underlying instrument. Market makers hedge any remaining risk. They do not charge commissions. 2. Hedgers - those businesses that require the insurance provided by the derivative and are prepared to pay the price (premium) for that insurance. E.g. an Australian gold miner might require a minimum gold price in Australian dollars to cover its production costs. The miner might use derivatives to ensure it can sell gold at that minimum price in AUD on a rolling monthly basis. A large scale miner may be able to accept it cannot precisely match its production volumes to the standardised contract terms. 3. Speculators - market participants who take on risk in the expectation of earning higher returns. This should not be confused with being reckless about risk exposures. Good speculators manage their risks by constantly monitoring their exposures, updating their forecasts based on market information, and watching market movements and trades to survive large losses at times and make large profits at other times. These speculators will know when to hedge their risks and when to close (sell out of) positions.

What is meant by the currency of liabilities?

Monies invested by retail investors will be used to fund the liabilities associated with a desired future lifestyle. Typically, those liabilities will be predominantly denominated in the home currency and be subject to the home country's economic policies. An institutional investor may also have most or all their liabilities payable in the home currency. Therefore, constraining an asset allocation to account for this will lead to a greater allocation to assets based in the home country and denominated in the home currency. However, this is partly an argument for maintaining a significant domestic currency exposure and not a domestic asset exposure. Currencies can be hedged using currency forwards.

For forward contracts, would the realised gain from owning the underlying asset be the same as the realised gain from entering the derivative contract?

No, realised gain/loss from owning the underlying asset is different from the realised gain/loss from entering the derivative contract. The payoff from buying the underlying asset at time t=0 and selling at time t=T would be price of underlying asset at expiry - price of underlying asset at time 0. The payoff from buying the derivative contract is the price of the underlying asset at expiry - forward price. Both outcomes would depend on the price of the underlying asset at expiry, but the amounts paid to get the exposure are not the same since the forward price does not equal the price of the underlying asset.

Explain how, with an example, OTC derivative dealers could hedge their risks.

OTC derivative dealers hedge their risks through entering similar, but often not identical, derivative trades to pass on the risk exposure they have taken on. Suppose a financial institution enters a derivative contract with a dealer where the institution buys protection against dollar movements. The dealer would then try to pass on the risk by engaging in a similar transaction to transfer the variability in the dollar to another party. This might be another derivative transaction on the dollar or simply a transaction in the dollar itself. Hedging a derivative with another derivative, even on the same underlying asset, is similar but never identical in terms. In order to do this effectively, complex quantitative models and specialised knowledge is required, which most companies do not have. Dealers, therefore, act as mediators to transfer risk through their ability to facilitate financial wholesale transactions in the derivative markets.

Explain the four heuristics.

People employ shortcuts or heuristics in their thinking when trying to make decisions under conditions of uncertainty. Four heuristics: 1. Anchoring and adjustment - a term used to explain how people produce estimates. People start with an initial idea of the answer ('the anchor') and then adjust away from this initial anchor to arrive at their final judgment. Thus, people may use experience or expert opinion as the anchor, which they amend to allow for the current conditions. The effects of anchoring are pervasive and robust and are extremely difficult to ignore, even when people are aware of the effect and aware that the anchor may be overstated or understated. The anchor does not have to be consciously chosen by the decision-maker. If the subsequent adjustments are insufficient, the final judgments will reflect the anchors, which may be arbitrary. Anchoring can have important implications for investment decisions, not least if individual investors rely on seemingly irrelevant yet salient data or statistics to guide their portfolio choices. 2. Representativeness - occurs because it is easier and quicker for the brain to compare a situation to a similar one - using System 1 thinking - than to assess it probabilistically on its own merits - using System 2 thinking. Representativeness is one of the most common heuristics and can, at times, work reasonably well. Nonetheless, similarity does not always adequately predict true probability. This is also related to the situation where people assess the probability of something occurring based on its occurrence in a small, statistically unrepresentative sample due to a desire to make sense of the uncertain situation. E.g. representativeness can lead individuals to base their decision on whether to invest in a particular stock, or not, on the basis of retrospective view of its price over a short recent period, rather than either its long-term movement or a more considered prospective assessment of the underlying fundamentals of the company. 3. Availability - characterised by assessing the probability of an event occurring by the ease with which instances of its occurrence can be brought to mind. Vivid outcomes are more easily recalled than other options that may require System 2 thinking. This can lead to biased judgments when examples of one event are inherently more difficult to imagine than examples of each other. 4. Familiarity - closely related to availability. The process by which people favour situations or options that are familiar over others that are new. This may lead to an undiversified portfolio of investments if people simply put their money in industries or companies that they are familiar with rather than in alternative markets or sectors. E.g. home-country bias is the tendency for people to disproportionally invest in stocks from their home country rather than forming an internationally diversified portfolio. E.g. the practice of many investors having portfolios of so-called blue-chip shares, which are usually companies with familiar names such as major banks or retailers.

Explain the payoffs and profits for buyers and sellers of put options.

Put options provide the holder the right to sell the underlying asset at the strike price and the holder will therefore exercise the put at the strike date(s) if the underlying asset is worth less than the strike price. Where: S_T is the price of the underlying asset at expiry X is the strike price of the option p_0 is the option premium Payoff to the put holder = Max(0, X-S_T) Profit to the put holder = Max(0, X-S_T) - p_0 Payoff to the put writer = -Max(0,X-S_T) Profit to the put writer = -Max(0,X-S_T) + p_0

Draw and explain the payoffs and profits for buyers and sellers of call options.

Refer to notes for diagrams. Where: S_T is the price of the underlying asset at expiry X is the strike price of the option c_0 is the option premium Payoff to call buyer is Max(S_T - X, 0). Profit to call buyer is Max(S_T - X, 0) - c_0 Payoff to call seller is -Max(S_T - X, 0) Profit to call seller is -Max(S_T - X, 0) + c_0 Call option buyer has unlimited upside potential and a limited downside loss equal to the initial premium paid for the option. Option writer has a limited gain equal to the option premium if the option expires without being exercised and an unlimited loss (potentially capped at zero, depending on the underlying asset).

Draw and explain the payoffs and profits for buyers and sellers of forward contracts.

Refer to notes for graph. If the price of the underlying asset at expiry < forward price, the long party makes a loss. If the price of the underlying asset at expiry > forward price, the long party makes a profit. The payoff to the long party is the price of the underlying asset at expiry - forward price. The payoff to the short party is, therefore, forward price - price of underlying asset at expiry, i.e. -(Payoff to long party). Note that the long and short party entered a zero-sum game; the profits to one party are exactly the losses to the other party. Except for the unlikely event that the price of the underlying asset at expiry = forward price, either the long party or the short party will be in the money at maturity (i.e. have a profitable position through the derivative exposure). If the price of the underlying asset at expiry = forward price, then there is no profit and the contract is closed at the money.

List some of the effects that regulatory framework can have on asset selection.

Regulation can have a big influence on the type of assets an investor can select. Therefore, certain assets might be more appealing in some countries than others for matching purposes. Regulatory controls and requirements could result in: - certain assets being permissible and other assets being restricted—e.g. loans to brokers have zero value in the prudential returns; - a limit on the amount of an asset that can be considered for solvency purposes—e.g. the market capitalisation of a share must not exceed 10% of a specified index; - a requirement for currency matching—but note the comments above on currency hedging; - limits on the maximum exposure to a single counterparty—e.g. no asset must exceed 5% of the portfolio; - specified amounts of certain assets required to be held—e.g. government bonds; - mismatching reserves to be held and usually increase as the degree of mismatching increases; and - restrictions on the extent to which mismatching is allowed.

Discuss the relationships between capital requirements, risk and investment strategy.

Regulators require banks, insurers and other financial institutions to hold capital, often referred to as shareholder equity, to reduce the probability of insolvency. The amount of extra capital that needs to be maintained is, or should be, responsive to the asset profile and investment strategy adopted. Riskier investment strategies are expected to provide higher expected returns. However, a company or fund attempting to improve returns through riskier investment strategies also risks higher losses if these strategies underperform. Riskier investment strategies may, therefore, require additional capital to be held to protect against such losses. The risks inherent in the relationship between an insurer's or fund's liabilities and the assets backing those liabilities can be categorised as follows: - Inadequate returns: The return on assets, which comprises both income and capital gains, may be insufficient to enable obligations to be met as they fall due. - Illiquidity: Assets may lack liquidity, making it difficult to generate adequate cash flows to pay obligations as they are due. This is different from the point above, although if illiquid assets need to be sold quickly, in which circumstances a low price may well eventuate, the same outcome will arise. - Reinvestment risk: Asset cash flows due for reinvestment may attract worse returns than originally expected. This is termed reinvestment risk and is relevant where benefit guarantees are offered many years before the premiums or contributions are received. - Mismatch risk: If asset cash flows do not exactly match the liability cash flows, then there is a mismatch between the two cash flows. A mismatched portfolio that contains fixed interest bonds is at risk if interest rates change, as explained later in this module. - Credit risk: With fixed interest assets, there is the risk of default. There is also the risk of price falls if the difference between the yield on the bond and the risk-free interest rate increases—the credit spread. - Volatility risk: It may be argued that if assets do not need to be realised or sold for some time, short-term volatility in asset values does not matter. However, if the value placed on those assets for reporting purposes—which is often market value—falls, then this may cause reported losses or even threaten solvency—where the value of reported assets is less than that of liabilities. If a fall in asset values occurs and a company or fund holds additional capital for adversity, then the value of assets may remain higher than that of liabilities. However, in this situation, the company or fund may still be considered to have a shortfall relative to their target capital level, which needs to be addressed. The volatility of asset values or investment returns can be a significant source of risk and may add significantly to the required amount of capital for companies. Retirement funds may not be subject to the same capital requirements as insurers due to explicit or implied guarantees from the sponsoring employer in the case of DB funds or because the member bears the investment risk in DC funds. The volatility of asset values and returns will still impact retirement fund member security and may affect the required future employer contribution rate in DB funds. Where cash flows under liabilities are well matched by future cash flows from investment assets, there is lower asset risk and, therefore, lower capital levels are required. A simple example of a well-matched liability is a pure endowment policy matched by a fixed interest security with the same interest rate and term. While the matching of assets to liabilities may minimise regulatory or capital requirements and reduce the volatility of surplus or profit, it may not produce optimal returns. Optimal, here, means the best expected returns given the objectives and risk tolerance of the company or fund.

Briefly explain the reinvestment risk that is faced by retirement funds and insurers.

Reinvestment risk is one type of investment risk faced by retirement funds and insurers. For regular premium business, policy terms are often set well before premiums are received and invested. In this case, matching may only be possible through the use of derivatives. For example, interest rate futures could be used to lock in current interest rates until future cash inflows can be invested.

Explain what is meant by the risk appetite of an organisation.

Risk appetite is the level of risk that an organisation is prepared to accept in pursuit of its objectives before action is deemed necessary to reduce the risk. Companies, funds and individuals often have multiple objectives resulting in competing priorities, each with its own risks. Establishing the risk appetite must allow for all these competing priorities, together with any other constraints such as an internal governance process or external regulatory controls. When a company or fund sets an objective, it needs to consider the risks and capital requirements relating to the objective.

Discuss the risk and return characteristics of private equity (use SYSTEM T).

Security - Private equity usually means companies too small for listing, or closely held e.g. family business, or start-up companies. In any of these, there are high risks the company is not profitable or fails altogether. Capital is not secure. However if the company is successful in growing and returning a profit, the company value may increase significantly over time generating significant capital gains. Yield - Dividends are not guaranteed, may not be any, particularly if the company is in start-up/development phase. Spread - The difference between the shareholder's required sale price and market bid price could be wide due to differing views of the company and/or low interest by buyers. Term - Usually expect to hold for several years as a minimum. Expenses - Costs of transaction to buy or sell could be significant. Marketability - Not easily marketed until company reaches scale and demonstrates profitability. Tax - As likely low or no dividends, tax will primarily be incurred when shares are sold and only if there is a capital gain.

Discuss the risk and return characteristics of investing in the equity of a large blue-chip share (use SYSTEM T).

Security - Share price can vary day to day but 'blue chip' suggests it will over a longer term hold its value, however during market shocks it may have a significant reduction in capital value - dividend income not guaranteed although likely to have been stable over time - future dividends may vary over time or even be nil. Yield - Dividend yield likely to be fairly stable except in periods of economic or industry shocks - may reduce if company is mismanaged. Spread - Since it is a large listed blue-chip share, the stocks are likely to be actively traded (daily) and hence would have a relatively small bid offer spread. Term - A measure of the term of an equity investment is the average holding period. This can vary depending on the investor. An individual investor who is speculative may have a very short timeframe, whereas a superannuation fund would have a very long timeframe. Expenses - The expense of purchasing a listed share is the share market fees and any brokerage costs. These are relatively low compared to other asset classes such as property, albeit higher than government bonds. Especially low expenses as the bid offer spread is small for a large blue-chip stock. Marketability - Highly marketable due to it being a listed stock (except under exceptional circumstances). Tax - Australian dividends may be 'franked' at company tax rate which may benefit Australian investors with a lower tax rate

Discuss the risk and return characteristics of direct property (use SYSTEM T).

Security: Land is relatively secure asset, but the buildings may be damaged or destroyed so it is essential to have insurance to protect the capital invested into buildings. The bigger risk is the security of the rental income as tenants may default or premises may be unoccupied for long periods. Rental income is the main driver of returns and value. There is also sovereign risk as the government may resume the land or rezone its allowable uses. Yield: Rental income is usually indexed (inflation-linked), providing a return with a real yield. As a result, property is considered a long-term store of real value. Once tenants are in place the income is reasonably predictable. Spread: Rental income is reasonably predictable; however, capital values of property can move up and down (significantly), reflecting economic conditions, buyer sentiment, supply and demand. Consider the buy/sell spread as the difference between buyer's offer and seller's expectation. Valuation is subjective and there may be a wide gap between the seller's valuation and the buyer's valuation, and a forced sale may see a significant sell spread adverse for the seller. Actual transactions may be too infrequent to give meaningful guidance on a current valuation. Term: Whilst freehold land ownership is a perpetuity, the building will require regular refurbishment and eventually replacement. The remaining usable lifetime of the building is important. The remaining term of the tenant leases in place will be a major input to a property valuation. Usually valued using a term of 10 years or more. Expenses: Transactional expenses can be significant, i.e. to prepare and promote the property and then conduct negotiations between the seller, purchaser, financier, manager and tenants. Ongoing expenses are also significant, such as maintenance costs, management costs, and insurance, although some (not all) can be passed through to tenants. These costs should be taken into account when agreeing tenant rents and when valuing a property. Marketability: Individual properties are not liquid investments and finding a seller/buyer and completing a transaction can take some time. Changes in demand, zoning, building regulations, etc. may mean a property becomes unsellable. Listed property trusts are one way to access property with more liquidity. Tax: Generally, there will be property-related taxes (e.g. land tax), transactional/acquisition taxes (e.g. stamp duty), as well as income and/or capital gains taxes. However, expenses may be tax-deductible. Overall taxes can reduce the return to the investor and need to be taken into account when considering if the property net returns will support the investment objective.

Discuss the risk and return characteristics of indirect property (use SYSTEM T).

Security: The underlying properties are likely secure assets, although their market value may fluctuate. The indirect portfolio may therefore have variable unit prices and no guarantee that capital value is protected over time. Yield: Rental income is usually indexed, providing a return with a real yield. Once tenants are in place the income is reasonably predictable. A well diversified portfolio should mean a stable/predictable overall income. The risk is a property downturn in demand (or oversupply) leading to lower rents and/or vacancies across the portfolio, reducing income to the unit holders (as well as capital values). Spread: The capital value of property can move up and down (significantly). Also, valuation is subjective and there may be a wide gap between the seller's valuation and the buyer's valuation, and a forced sale may see a significant sell spread adverse for the seller. Depending on composition of portfolio, this risk may be diversified away or aggregated. Also a trust may have significant differences in buy/sell unit prices depending on the nature of the trust, net cashflows, and costs to transact on properties. Term: If the portfolio is open-ended and unitized, the trustee can buy/sell units at any time. However, the unit price at the exit date can't be known in advance, and there may be liquidity issues. Expenses: Transactional expenses can be significant. Ongoing expenses are significant to maintain a property although some can be passed through to tenants. These costs are built into the unit pricing of the portfolio. Marketability: Using a listed property trusts is one way to access property with more liquidity and be confident of being able to exit at the end of a certain investment period. A closed trust or mandate may not allow a full withdrawal by the investor at a particular date. Tax: Generally, there will be property related taxes (e.g. land tax), transactional taxes (e.g. stamp duty), as well as income and/or capital gains taxes. However, expenses may be tax deductible. Overall taxes can reduce the return to the investor and need to be taken into account when considering if the property net returns will support the investment objective.

Discuss the risk and return characteristics of money market instruments (use SYSTEM T).

Security: This will depend on the issuer — for example, investing in a short-term government instrument will generally be more secure than a short-term loan to a manufacturing company. However, short-time frames often suggest that the security would be good. Yield: real versus nominal. Money market instruments tend to have rates similar to official rates set by monetary authorities. These amounts will vary over time, with some instruments providing a known nominal return, such as a bill offered at a discount to face value, and other instruments having returns linked to inflation. Investors will mostly expect to achieve a positive real return, although this is not always true (e.g. during the 70s). In order to achieve positive real returns, short-term rates tend to rise with inflation. Yield: expected return relative to other assets. Money market instruments are close to risk free as they tend to have a low risk of default. As a result, the expected returns will have a negligible risk premium and generally offer lower returns compared with other asset classes. Spread: volatility of capital values. Due to the short-term nature and fixed nominal returns, these instruments tend to have low levels of volatility, with no volatility for cash deposits. Term: The term for these instruments is usually less than one year, with the majority being very short, such as overnight deposits. Expenses: Expenses are relatively minimal for these types of transactions. Exchange rate: Money market instruments are available in most currencies and will introduce exchange-rate risk if it is bought in a foreign currency. Theoretically, movements in exchange rates are expected to compensate for interest rate differentials; however, in practice, realised exchange-rate movements can be unpredictable and very volatile. Marketability: This depends on the instrument with some instruments not being marketable, for example call and term deposits. Other instruments can be highly marketable, but these tend to be through the interbank money market. Tax: Common practice is to treat the total return as income for tax purposes.

What is meant by the term of liabilities? What happens when you invest longer than the term of the liabilities?

Some liabilities can be extremely short-term, e.g. medical insurance claims, whereas other liabilities can be very long-term, e.g. annuity payments. Investing longer than the term of the liabilities involves a risk that the entity needs to sell early, at depressed prices. Investing assets shorter than the term of the liabilities introduces reinvestment risk although that may be unavoidable for some long-term liability contracts.

Describe the two processes of a derivative trade that are supported by standardisation.

Standardisation also supports two further processes: 1. Clearing - process through which an exchange validates a trade and records the transaction. Done electronically. 2. Settlement - process whereby the exchange facilitates the transfer of funds and assets accordingly between the various parties. Settlement is a vital component of derivatives trading as there would be no trust in the markets if funds were not effectively and accurately collected and distributed. Derivate exchanges clear and settle contracts overnight, whereas security exchanges generally have a two-day lag.

Explain how a swap works.

Suppose Company A has a bank loan from Bank X that is at a floating rate - that is, it is variable. Assume Company A would prefer a fixed rate in order to plan cash flow requirements going forward. Company A can convert the floating rate loan into a fixed-rate loan through a swap. The loan payments are based on a floating rate If Company A can enter into a swap where it agrees to pay a fixed rate in exchange for receiving floating payments based on the same underlying rate as the loan payments, then Company A would have effectively converted the floating-rate loan into a fixed-rate loan. Company A's loan with Bank X would have an actual balance. It is worth noting that the swap does not have such a balance; instead it has a notional principal, which is used to calculate the actual amounts payable. If Company A's loan has only the principal payment remaining (the final repayment), then the swap will need to be negotiated with a pre-specified declining notational principal schedule that corresponds to the declining loan balance over the remaining term.

Discuss the need for a consistent valuation approach to both assets and liabilities.

The actuary needs to understand the asset valuation method applied and consider the consistency between assets and liabilities, including whether any adjustment is required. Consistency of methodology and approach in valuing assets and liabilities is important if financial reports are to be meaningful and effective in communicating the financial position of a company or fund. Consistency is also important in determining an appropriate employer funding rate for DB retirement funds. Accounting standards increasingly aim for consistency in reporting where possible, including across different industries. This suggests that the assets of insurers and retirement funds should be valued using the same methods as those applied to the valuation of assets of non-insurance companies. "Fair value" asset valuation is increasingly being adopted in international accounting standards to achieve consistency between entities and industries. However, even where fair values are adopted, exceptions may be allowed for specific assets and certain circumstances. For instance, some assets may be valued at cost, such as investment property, other property, plant and equipment, and investments in subsidiaries, associates and joint ventures. Actuaries need to understand the asset valuation methods applied and how asset values may vary over time. If an actuary has concerns over the consistency of approach between the valuation of assets and liabilities, these need to be raised and compensating adjustments to the value of liabilities may be required. Actuaries also need to understand and may need to adjust the asset values used for capital adequacy purposes. For example, investments in controlled entities may be discounted or valued at zero for capital adequacy purposes. This is because the value of these assets is expected to drop significantly (or be lost altogether) if the company or fund faces an extremely adverse experience. In calculating recommended funding rates, an actuary may, in some limited instances (such as during a time of extreme market volatility), value some assets using a smoothed "trend" value. A smoothed value can be calculated by adjusting current market prices based on the underlying long-term trend line or curve of an appropriate asset index. Alternatively, a smoothed value may be based on the discounted value of expected future cash flows from the assets under consideration. In such circumstances, the use of smoothed asset values would produce better consistency in the valuation of assets and liabilities and a more sensible funding rate.

What is meant by the uncertainty of liabilities?

The amount and timing of payments are uncertain, for example, insurance claims are random. The lower the certainty of the amount and timing of payments, the higher the requirement for investments in more marketable securities. The level of uncertainty will decrease as a portfolio of similar liabilities increases in size.

Explain the concept of immunisation. Discuss the assumptions required, the validity of these assumptions, and its benefits/drawbacks.

The classic example of approximate hedging is Redington's theory of immunisation. Immunisation is a strategy for managing an investment portfolio that is particularly relevant to debt security portfolios. It ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunisation can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount of their liabilities, thus leaving the value of the pension fund's surplus or firm's equity unchanged, regardless of changes in the interest rate. The immunisation conditions are that the duration of the assets and liabilities are equal and that the convexity of the assets exceeds the convexity of the liabilities. It is assumed that the beginning asset value equals the beginning value of the liabilities. Interest rate immunisation can be accomplished by several methods, including cash flow matching, duration matching, and volatility and convexity matching. It can also be accomplished by trading in bond forwards, futures or options. Interest rate immunisation requires constant management because, in principle, the portfolio is only immunised for a moment in time. Seconds later, particularly in a volatile market, interest rates and bond prices may have moved, requiring a re-balancing of the portfolio to immunise it for the remaining investment horizon. However, this must be managed to contain transaction costs. Immunisation has some flexibility compared to a dedicated bond portfolio, creating possibilities to take some active positions. For instance, you may be duration matched and convexity matched, but you may take some bets on sectors or security selection. This explains why immunisation approaches are sometimes referred to as duration-neutral strategies. The assumptions that are required for immunisation to work are: - the yield curve moves in small parallel shifts; - the yield curve is flat; and - the cash flows being measured are not sensitive to interest rate movement. These are unrealistic because: - the relationship between bond prices and yields is convex but using duration as the sole risk measure assumes a linear relationship; - the yield curve can have large shifts, as well as non-parallel shifts, which may be because short rates respond to monetary settings of the central bank, whereas longer rates reflect bond risk premiums, expected future cash rates and inflationary expectations; - the yield curve is rarely flat; it normally has an upward sloping shape but can be inverted from time to time; and - for some types of bonds, cash flows are interest sensitive, which further impacts the volatility of bond prices to interest rate movements. An example is mortgage- backed securities, where more mortgagors will prepay their loans early if rates fall to refinance at a lower interest rate. The following should be noted about immunisation: - it does not remove liquidity risk; - it does remove interest rate risk, provided the Redington assumptions hold; - the liability is fully funded, provided the Redington assumptions hold; - constant re-balancing is required; and - there are practical constraints in managing any fixed interest portfolio. For immunisation, a common one is that you cannot find bonds with a sufficiently long duration, particularly for many of the liabilities that actuaries are likely to encounter. In summary, immunisation is a low-risk style that seeks to match the main risk parameter of the asset and liability portfolios—duration. However, immunisation is based on certain assumptions that are not realistic in the real world of bond markets. Given that the focus is on duration matching assets and liabilities (as well as convexity for assets exceeding convexity for liabilities), there is considerable flexibility in structuring immunised portfolios. An "enhanced" approach may be followed to add value at the margin or to provide additional security. Examples of these enhancements include: - combination matching (or horizon matching) which involves duration matching and also cash flow matching for the shorter term liabilities; - contingent immunisation; - futures overlays to contain overall duration; and - options strategies to enhance returns. With the flexibility described above, immunised portfolios can usually be constructed at a lower cost (i.e. higher expected return) than dedicated portfolios (where all expected liability outflows are matched to an asset inflow—this is perfect matching and requires, in theory, no ongoing management).

Explain the role of the clearinghouse in the exchange-traded derivative market. How do they limit their own risk?

The exchange's clearinghouse novates the contract (i.e. replaces the original contract between the buyer and seller) and becomes the counterparty to both the buyer and the seller. This process guarantees both sides of the trade. The clearinghouse guarantees that the party making money will receive their payout regardless of whether the other party defaults, thus taking on the credit risk. This is important as by the time of settlement, one party to the trade would be losing money on the derivative contract while the other party would be making money. The clearinghouse limits its own risk to the counterparty defaulting by requiring initial cash on deposit, called initial margin, from both sides of the trade. This initial margin is then adjusted at the end of each subsequent day to reflect profit/loss from the unrealised gain/loss as a result of the daily movement. The party making a profit is then able to withdraw some of their margin, whereas the party making a loss needs to increase their margin, called variation margin, to reflect the increased credit risk it represents. Valuation margin is required when the margin account balance has fallen below the maintenance margin level, which is the minimum balance amount that needs to be maintained for a position to remain open.

Draw and explain the payoffs and profits for buyers and sellers of futures contracts.

The futures price must converge to the spot price at expiration. For forward contracts the payoff is the price of the underlying asset at expiry - forward price. Futures have a similar payoff, except for interest on the cash flows arising from the daily settlement process. The futures price must converge to the spot price. Forward contracts would only realise the full gain or loss at expiration, whereas futures contracts realise the gain or loss incrementally over time leading up to expiration.

Describe the main market participants in the OTC derivative market.

The primary participants in OTC derivative markets are banks, with the majority being members of the International Swaps and Derivates Association (ISDA). ISDA is a global organisation of financial institutions transacting primarily as dealers in derivatives. ISDA members trade in derivatives informally in that they are not obliged to create a market, contrary to exchanges that guarantee a market.

Explain the concept of exact matching.

The primary principle of investments is that the selected assets should be reflective of the nature, term, currency and uncertainty of the liabilities. If there was no uncertainty in the liabilities, then it may be possible to purchase assets that provide a perfect match. In exact matching, there is no mismatch - values and cashflows exactly same on both asset and liability sides all the time. This is possible for investment linked liabilities, but otherwise only in very limited circumstances. In general: - Except for investment-linked liabilities, there is uncertainty in the amount and payment of liabilities; - Liabilities often include optionality and hence uncertainty, which makes it challenging to match perfectly; - Liabilities may include discretionary benefits; and - The asset universe available might not be broad enough. A perfectly matched portfolio is therefore unlikely to exist in practice, which results in some residual level of risk. Investors typically hold additional capital to provide the freedom to leave certain liabilities unmatched to invest in non-matching assets to achieve potentially higher returns.

What are the two primary principles of the ALM process?

The primary principles of the ALM process are therefore that: 1. Assets should be selected that are reflective of the needs and objectives of the investor, including the investing party's risk appetite; and 2. Assets should be selected to maximise the total return on assets, where total return can include both income and capital gains.

Give five examples of categories of policy liabilities/member benefits where investment strategies are customer-driven.

The types of products sold, or funds provided, will also impact the choice of a suitable investment strategy for the assets backing them. There are categories of policy liabilities or member benefits where investment strategies are governed by either customer expectations about future returns or customer-selected investment options. Five examples are: 1. Investment-linked or index-linked policies: Under investment-linked or indexed policies, the policyholder receives returns based on a selected investment strategy or index. This creates an obligation to invest proceeds according to a particular investment mandate or approach. The policyholder expects investment returns to move in line with the chosen strategy or index. For investment-linked policies, product documentation may include specific limits—maximums and minimums—on exposure to various asset classes such as shares, property and fixed interest securities. A matched strategy is one that aligns with that promoted in the policy documentation. 2. Defined contribution (DC) retirement benefits: Are calculated as contributions less fees or costs plus investment returns and have benefits determined on a similar basis to investment-linked or indexed life insurance policies. Retirement funds providing DC benefits may invest in investment-linked policies to support those benefits. 3. Participating business: Participating or other discretionary investment business policyholders are entitled to a share of profits. Profits include investment earnings. In setting an investment strategy, regard must be had for the reasonable expectations of policyholders. The promotional material for these types of products gives a broad indication of the types of assets the company intends to use to back the liabilities. 4. Guaranteed benefits: Many types of policies and benefits are guaranteed. For example, term insurance, non-participating annuity benefit amounts and the basic sum assured, together with any declared reversionary bonuses in participating endowment insurance, are guaranteed. The benefits under a DB fund are usually based on average final salary and period of membership with no adjustment for investment performance. Expected returns on supporting assets are an important part of the funding of guaranteed benefits. 5. Life company shareholder equity: Where assets exceed liabilities, the excess is referred to as surplus assets or, for a proprietary life company, shareholder equity or shareholder capital. Surplus assets do not necessarily back specific policy liabilities but support the security of the company or fund generally. The investment strategy for these assets is modified accordingly. The risk and return objectives of the company or fund, the need for and potential uses of shareholder equity, and the potential sources of additional capital, if needed in the future, will all be considered.

List and explain the 5 main steps involved in the ALM process.

There are five steps involved in the ALM process: 1. Identify the needs of the investor The needs of the investors are determined by: - Examining the liabilities of the investor by considering the nature, the term, the currency, and the uncertainty - Understanding the capacity to access capital in excess of their needs; - Understanding their risk appetite; and - Any regulatory or legal constraints. 2. Set objectives - State any assumptions you have to make to fill in your knowledge gaps. - Propose investment objectives that align with the investor's needs. - Investment objectives should be unambiguous and clearly quantified as far as practically possible. - Investment objectives should include the allowable degree of risk, often defined in terms of the institution's risk appetite, together with the required return as well as any other objectives such as meeting cash flow requirements. - The objectives can be framed in various ways, sometimes with competing priorities. It is therefore important to define what the objectives are and the priorities for achieving them. - Institutional investment objectives often incorporate goals for returns; risk; timeframe; and liquidity. 3. Determine the available strategies - Discuss the investment strategies that may be suitable. - Consider asset allocation, direct and indirect options, liquidity, matching and costs. - Investment strategy refers to the rules and tactics used to guide an investor's selection of investment portfolios. - A strategy is put into effect through the acquisition, management and disposal of investment assets. - Portfolio management may be partially or wholly outsourced, especially for smaller companies and funds. - However, in selecting and executing investment strategies, many of the considerations of a company or fund are the same whether portfolio management is outsourced or conducted in-house. 4. Assess the strategies and select one - Assess and compare various proposed strategies and compare them to the hypothetical perfectly matched strategy. - Each strategy will be evaluated for its impact on the risk and return outcomes for the investor and its ability to achieve the company's or fund's financial objectives. These objectives might include: maintaining solvency; maximising profit or surplus; minimising profit or surplus volatility; maintaining the employer contribution rate or insurance premiums within a target range; minimising regulatory capital requirements; maximising a company's appraisal value; and maximising expected return on capital (i.e. profit divided by capital). - Once all the available alternatives are assessed and compared, the most appropriate strategy can be selected. - It may be that none of the strategies provides a perfect fit; then, the investor may have to prioritise their objectives and assess whether there is a 'best available' solution that will be appropriate. 5. Document and implement. - Document the chosen strategy (objectives, constraints and asset allocation), operational parameters, performance objectives and the process for future monitoring and reassessment. - Finally, the investor (board or trustee) has reached a point where a documented investment strategy can be handed to the investment team to implement. This team may be in-house employees or an outsourced investment manager or some combination. - The investor will then monitor results against objectives and update or amend the strategy in response to experience.

Explain the reasons AGAINST the use of derivatives.

Two main arguments against derivatives: 1. Allow for speculation which could contribute to asset bubbles 2. Lead to systemic risk, which destabilises financial systems - In order for derivatives to be used to manage and transfer risk where an investor is not comfortable bearing the risk, there must be another party involved in the trade who is willing to accept the risk. - As a result, derivative markets consist of both hedgers and speculators. - The more speculators there are actively involved in the derivatives market, the easier it is for hedgers to transfer their risks. - Speculators are often hedge funds and other professional traders who are risk seekers in the hope of achieving higher returns to compensate them for taking on the risks. - Where speculation is used for long-term risk management in the financial system it is seen as a genuine service to society as a whole, similar to insurance companies who make claim payments over time. - However, some speculators (gamblers) attempt to exploit short-term temporary market inefficiencies without consideration of any long-term detrimental effects. - Gamblers tend to trade at extreme prices in the hope of making short-term profits and have been caught in the past for market manipulation. - This form of speculation is seen as a disadvantage of the derivative market and has increased regulation attempts to limit it as far as practically possible. - However, OTC derivative markets specifically have less transparency, more flexibility, and less regulation, which makes it possible for some of these rogue traders to try to game the system without considering broader financial impacts. - Speculation is also perceived to have a potential destabilising effect on financial systems and a country's economy. - Derivative markets have been under intense scrutiny since the GFC, with some questioning whether derivatives act as an adverse incentive for increasing the sort of speculation that leads to price bubbles. - The argument is made that speculators use excessive amounts of leverage and therefore expose themselves (and as a result the hedgers to the trade) to significant risk if markets move against them. - Thus, speculator defaults could have a ripple effect and lead to systemic contagion throughout an economy and even globally. The GFC was a prime example of such an event where central banks and governments had to step in and bail out banks and insurance companies who did not manage their exposure to such risk appropriately. - These types of events have led to increased regulation and restrictions around the use of derivatives. - Finally, derivatives are also criticised for being extremely complex, with the result that investors often do not know what their actual exposure is unless they have an advanced qualification in mathematics. - An important component of using derivatives is understanding their use, limitations, and associated risks when developing portfolios and strategies. - As with any other asset or instrument there are associated risks and benefits of using derivatives, although there is the potential for serious exposures to develop very quickly.

When dealing with options, what is meant by the term 'intrinsic value'?

When dealing with options, the term intrinsic value is a measure of the current relation between the value of the underlying asset and the strike price. The intrinsic value does not represent the value of the option as it does not consider what may happen at points in the future before the expiration date. The extrinsic value, or time value of the option, needs to be added to the intrinsic value to determine the option's price.

What is meant by the nature of liabilities?

While there are many different types of insurance policies and superannuation systems, the nature of the benefit payments may be categorised into four types: 1. Guaranteed in nominal terms - Benefits that are contractually expressed in monetary terms at contract outset - E.g. claim from a term assurance policy where the sum insured was specified at the outset. - Conventional bonds and other money market instruments, of suitable durations, provide a match for nominal payments. 2. Guaranteed in terms of an underlying index - If a benefit is guaranteed in terms of an underlying index, then the benefit payment is linked to an index. - The index needs to be specified but is not restricted to national price or earnings indices. - E.g. annuity payment where annual increments are in line with a government-published inflation index. - Assets that have values based on the same underlying index, such as index-linked securities, are the most suitable assets for benefits that are guaranteed in terms of an underlying index. - Aim would be to also achieve the same expected term as the liability payments. - However, it will be difficult to find assets that are linked to specific indices that are not government price indices. 3. Discretionary - Some benefit payments are at the discretion of the provider. - E.g. a DB fund may increase pensions in payment at a higher rate than contractually agreed. - Participating business, also known as with-profits, technically has the discretion not to declare future bonuses but past practice often leads to an expectation that there will be declared bonuses. - As discretionary benefits are not guaranteed, the main objective would be to maximise the value of the discretionary benefits and, therefore, the most appropriate investment strategy would be one that is expected to provide the highest return. 4. Investment-linked - Benefits that are directly linked to the value of the assets are investment-linked benefits. - Investment-linked liabilities are based on the movements of a defined pool of assets or index and can therefore be calculated using a specified formula. - The simplest way to achieve matching for investment-linked is through investing in the same underlying pool of assets or index. - Depending on the size of the index, this might become too costly and institutions might try to achieve this via synthetic structures such as derivatives.