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Asset Liability Management

5. DEBT SECURITIES

5.1 Overview

5.1.1 What this module covers

·       Debt securities are debt instruments (i.e. contracts) that can be bought or sold between two parties.

·       They have agreed terms such as interest and maturity date

·       A debt is created when the security is issued, whereby the issuer (or borrower) owes an agreed set of payments (how interest calculated and capital payment at maturity and when to pay them and its timing) to the investor in the debt security.

·       Risk of debt security -> possibility that the agreed payment terms are not fulfilled -> borrower defaults on repayments of interest or principal payments

·       Debt can take different forms:

o   Defined in terms of a local or foreign currency or by reference to an index such as a CPI

o   Can have fixed or variable rate of interest

o   Can be repayable at a fixed date or perpetual debt with no fixed term for repayment

o   May be tradeable on an exchange (or any organised market) to be sold before the maturity date

5.1.2 Setting the scene

·       Global bond (debt) markets far outweigh global equity markets in both market value and annual issuance.

·       Bond market is a key source of capital for business and gov’ts -> investment opportunity for institutions as well as individuals

·       Investors are attracted to investment in debt securities -> compared with equity or property debt securities offer (near) certainty of the agreed payments, which usually include interest payments and the return of capital at a set point or points in time.

o   Enables them to arrange their financial affairs to meet their liabilities with more certainty

o   Trade-off for less uncertainty -> accepting a lower long-term return on debt securities compared to equity or property.

5.2 Main types

5.2.1 Overview    

Well-known types of debt  securities

Examples

Deposit

Cash, term deposit

Money  market security

Certificate of deposit; Bill of exchange (including bank bill);  Promissory note; Treasury note; Repurchase agreement

Debt  market security

Government bond; Corporate bond; Floating rate note; Inflation-linked  bond

 ·       Cash instruments in money market (<1 year maturity) and debt capital market (>1 year).

·       Debt securities are used to build derivative investment products:

o   Mortgage-backed security (MBS)

o   Collateralised debt obligation (CDO)

o   Credit default swap (CDS)

5.2.2 System T

·       Characteristics that influence the risk and return expectations of the asset class or security under consideration:

o   Security (i.e. default risk where agreed payments of interest or capital are not made)

o   Yield (i.e. real/nominal, expected return/running yield relative to other assets)

o   Spread (i.e. expressed as a required margin of yield over government securities of the same term to compensate for increased risk of default)

o   Term (i.e. short, medium, or long, expressed in remaining years to maturity)

o   Expenses (i.e. dealing and management) or Exchange rate (i.e. currency risk)

o   Marketability (i.e. tradeable on an exchange or market, liquidity related to volume traded, or non-tradeable, or illiquid

o   Tax

5.3 Deposit securities

·       Are debt that arises by an investor placing (deposit) their money with a bank (or any building society or credit union) and receiving interest on the amount deposited.

·       Deposit taker in Australia must be an authorised deposit-taking institution (ADI) -> bank, credit union or building society under the supervision of the regulator -> APRA

·       They are either at-call deposits -> investor can have access to the deposit at any  time or term deposits -> investor cannot access their account for an agreed period.

5.3.1 At-call deposits

·       Depositor/ investor has instant access to withdraw the deposit or required to provide a very short notice period before withdrawing their capital.

·       Fees maybe charged or adjusted with interest payable to cover expense recovery and profit margin.

·       Cash deposits often called sight deposits or call deposits

Return

·       No capital gain and investment returns are interest paid by issuer of the security (deposit taker). Interest can be:

o   Fixed for the duration of the deposit

o   Fixed for an initial period and then varied

o   Variable day on day

o   Higher or bonus rate paid if certain conditions are met e.g. no withdrawal

·       Cash rates are usually linked to central bank’s cash rate (used to achieve target inflation).

·       In Australia, over long-term, cash rates have been higher than inflation -> good real return for the investor. But at times, with negative real return (e.g. COvid-19 where cash rate was 0.25% and inflation was 1.8% with real return of 1.55% p.a.)

Risk

·       Well-regulated economy -> lower likelihood of failure of cash deposit taker (except during GFC).

·       Gov’ts introduced a guarantee to reassure investors that their cash was ‘safe’ in local banks -> to prevent a run on banks’ capital.

·       E.g. Australia -> Financial Claims Scheme (FCS) -> protections to deposits in ADIs and to policies with general insurers if their fail (up to $250,000 per account holder).

5.3.2 Term deposits

·       Varying terms and conditions

·       Investor has no access to the capital before the end of the agreed period of time.

·       Can gain access to the funds earlier than the original term under certain conditions -> investor may be penalised e.g. loss of interest or payment of exit fees

·       It will also affect the expected return the investor will receive in order to compensate for the ‘loss of access’ -> issuer will likely to price deposit to balance for their need for capital now and expectations of future cash rates failing/rising (making it cheaper/more expensive to raise capital in the future).

·       Suits investors with known liabilities that require funding at a known future date or those with no specific liability but a strong aversion to loss.

Return

·       At-call deposits -> no capital gain and the return is interest paid by issuer of the security

·       Term deposit rates are quoted daily -> secure deposit to issue loans to customers

·       Factors affect term deposit interest rates set by banks:

o   Cash rates set by the central bank (RBA)

o   Market competition between banks for deposits

o   Banking regulations

·       Ex 5.1: Research the relationships between cash rates set by the RBA and the inflation rate.

What are your observations on the cash rate and inflation rate?

By what theoretical mechanism does the cash rate influence the inflation rate?

Is there evidence of this relationship?

o   The cash rate has essentially trended down since 1990 from 17.5% to 0.25%. For a reasonable period, it ranged between 5% and 7% pa; however, since the GFC (dropped) and recovery (rose) it has gradually been reduced to 0.25%.

o   The inflation rate has been more volatile and has remained within a smaller band (1% to 5% pa).

o   Economic growth tends to fluctuate around a long-term trend. When the economy grows too slowly because of weak demand, the RBA can lower interest rates to stimulate economic growth and employment. On the other hand, when the economy grows too quickly because of excessively strong demand, the RBA can raise interest rates to dampen economic activity and contain inflation.

o   It is important to remember that monetary policy is a tool used to smooth fluctuations in the business cycle. While it can help support long-term economic growth by avoiding costly recessions or financial crises, it cannot create long-term economic growth by permanently stimulating demand. Any attempt to do so results in higher inflation. Long-term economic growth is ultimately determined by the availability and productivity of an economy’s resources such as labour, land, and capital.

o   In May 2020 (cash rate 0.25%, inflation 2.2%) the RBA had no plans for further lowering cash rates with the most recent minute noting ‘The yield target [0.25% pa for 3 year bonds] was expected to remain in place until progress was made towards the goals for full employment and inflation’.

·       Interest rates for term deposits vary based on:

o   Term

o   Amount invested

o   Interest payment frequency

o   Early exit fees/penalties

·       Investor benefits if market rates declining during the term -> as they will be paid at the higher rate. But these expectations about the future will drive both investors and deposit takers when a new term deposit is issued.

·       Investors expecting a fall in cash rates -> seek longer term to lock in current higher rate for longer period. So banks offer lower rate for longer-term deposits.

·       Ex 5.2 Select one Australian ADI and obtain their term sheet. Figure 5.3: ANZ Term Sheet is an example of the ANZ Bank term deposit rates on 17 April 2020. What factors influence the rates being offered?

o   Term of deposit (longer term earns slightly higher rate)

o   Amount of deposit (higher amount earns slightly higher rate)

o   Cash rate — Small/short-term approaching cash rate plus a margin

o   Bond rates — Large/long-term approaching 10-year bond rate

o   Bank margins — All deposit rates are below the corresponding mortgage or business loan rate being offered to customers, to ensure a margin for the bank

Risk

·       Failure of a term deposit taker is very low in markets if the banking sector is regulated and supervised (similar to cash on deposit). But possible -> guarantee schemes by FCS apply to term deposits.

·       Investor accepts the risk of market interest rate increase during the term -> will not be passed onto existing term deposits. But can be broken (with penalty) to rest the interest rate.

·       Ex 5.3: How do the cash flows differ, in terms of timing and amount, between a fixed rate term deposit at a fixed interest rate and an instant access cash account with a variable interest rate?

o   All the cash flows are known in advance at the point of purchase in terms of timing and amounts for a fixed term deposit at a fixed interest rate.

o   The actual cash flows are:

§  One deposit

§  Repayment of capital at agreed time with accrued interest at agreed rate on amount deposited.

o   Contrary to this, the amounts and timing of cash flows are unknown at the point of purchase for an instant access account with variable interest.

o   The actual cash flows are:

§  Deposits and withdrawals by investor at any time, any amount

§  Credit of interest at the end of each agreed period (e.g. monthly) at the interest rate for that period applied to the daily account balance for that period.

5.4 Money market securities

5.4.1 General background

·       Basic structure -> an investor lends capital to a borrower for a short period (<1 year) at an agreed rate of interest (margin above reference rate). Then the investor receives capital + interest earned at the end of period.

·       Money market securities are issued at a discount to the maturity value (par), to reflect interest and then redeemed at par -> discount securities (return is earned due to the amortisation of the discount b/w time of issue and maturity date -> interest).

·       Short term (overnight or up to 365 days)

·       Money markets -> transactions in money market securities

·       Dominated by banks over other financial and non-financial institutions who manage their own liquidity -> issue if they need short-term capital or purchase if they have excess short-term liquid funds.

·       Central banks -> act as lenders of last resort to provide liquidity or use money market to establish short-term interest rates (via sale or purchase of certain money market securities and subsequent repurchase or sale at agreed price – repurchase agreements)

Return

·       Short-term interest rates (money market rate or Treasury bill rate) -> rate for short-term borrowings between financial institutions or rate at which short-term government paper is issued or traded in the market.

o   They are average of daily rates (as %).

o   They are based on 3-month money market rates

·       Investors use interest rate benchmarks -> assess current pricing for ST money market securities and observe historical experience.

o   Also used in corporate borrowing rates and in financial contracts (derivatives and asset-based securities)

·       Interbank rates have been the most common benchmark for short-term interest rates.

·       The RBA cash rate and BBSW (bank bill swap rate) continue as Australia’s key short-term interest rate benchmarks.

Risk

·       Money market securities can be attractive to risk-averse investors -> due to stability of capital values.

·       Over the long-term money market, securities are expected to provide a lower return than riskier or less liquid investments.

·       All securities in this market are short term, do not pay interest during the term, and have a fixed maturity date.

·       The key distinguishing characteristic between the types is the credit risk.

Types

·       5 types of money market instruments:

o   Certificate of deposit

o   Promissory note

o   Bills of exchange

o   Treasury notes/ bills

o   Repurchase agreements

5.4.2 Certificate of deposit (CD)

·       Is a term deposit that is traded between investors (cash term deposits are not tradeable)

·       Duration is usually 7-365 days

·       Features:

o   The ‘certificate’ acts as an acknowledgement for money that has been deposited with a bank — therefore, it is issued by a bank

o   CDs are freely negotiable — the initial investor can sell their certificate to another investor, who then has the right to receive the interest and capital from the bank

o   CDs are only issued if the amount is sizeable

o   CDs are issued at a discount to par, where the investor deposits say $0.95m and receives back $1m a year later, where the $0.05m difference is the interest payment

5.4.3 Promissory note

·       A written promise for the amount owed to a specified counterparty at a specified time or on demand.

·       Settled through the payment of the amount owed by the borrower (maker of the note) to the lender (the payee, or the bearer of the note).

·       Banks may issue promissory notes, these debt instruments allow funding from non-bank sources.

·       They are usually:

o   issued for relatively short terms, say 185 days or less

o   must be signed by the party making the promise

o   must be for a specific sum of money; must specify the time for repayment

o   must be in bearer form

o   are transferable by delivery without endorsement

o   are issued and traded at a discount

o   are redeemable at maturity

·       If it is unconditional and readily saleable -> negotiable instrument

·       Difference b/w an unsecured and a secured promissory note -> secured note is guaranteed by a certain asset (e.g. property or vehicle), whereas an unsecured note does not have any collateral associated with it.

·       Credit or default risk -> credit risk of the issuer as well as the value of the secured asset (if any).

·       Commercial paper -> an unsecured promissory note with a fixed maturity of < 270 days.

o   Is issued by companies for the purpose of raising capital directly from the market.

o   Returns are as good as treasury bills due to low security offered.

5.4.4 Bills of exchange

·       An unconditional order in writing, addressed by one person to another, signed by the person giving it (the maker or borrower), requiring the person to whom it is addressed (the acceptor -> usually bank) to pay on demand or at a fixed or determinable future time, a sum certain in money or to the order of a specified person (the bearer).

·       Negotiable instrument maturing within 6 months sold at discount (redeemed at faced value).

·       Can be also redeemed at another bank or broker at a discount.

·       If bank is the acceptor -> accepted bill of exchange or bank bill

·       The bank has endorsed the bill on the back, either through buying the bill in the market or for a fee to raise the bill’s status -> bank endorsed bill

·       Bank accepted bills -> Carries negligible risk of default  -> highly marketable

5.4.5 Treasury notes

·       Many central governments offer short-term debt securities that are guaranteed by that government and usually assumed by investors to be free of default risk (but not always).

·       Australian Treasury notes are a short-term discount security redeemable at face value on maturity. Terms are less than 12 months. Treasury notes are issued to assist with the Australian Government's within-year financing task -> low risk and secure investments.

·       Ex 5.4 In Australia, the most important types of discount securities are Treasury notes and bank accepted bills of exchange (bank bills). Determine the current value of these securities on the Australian short-term money market.

o   Two useful resource sites that will help are: https://www.aofm.gov.au/securities/treasurynotes and https://afma.com.au/

5.4.6 Repurchase agreements

·       Where the party willing to buy the underlying security provides the party selling the asset with temporary capital in exchange for the underlying security as collateral.

·       Very short term borrowing or lending (overnight)

·       Then the party selling the asset has an obligation to repurchase the asset at an agreed price (hence the term ‘repo’).

·       Important to maintain liquidity in the secondary market.

·       In Australia, each bank holds an exchange settlement (ES) balance with the RBA -> an at-call cash deposit, must be positive at all times. If not, they may need to borrow temporarily from another bank to provide cash for the ES balance to the RBA.

·       There are transactions between the government (RBA is the banker) and the commercial world (commercial banks) daily that change the ES balances via repurchase agreements.

·       To inject ES balances, the RBA provides cash to a bank and the bank provides eligible debt securities as collateral to the RBA. This protects the RBA from counterparty default losses by the bank. Then the next day, bank returns the ES balance and RBA returns the securities to the bank.

·       Therefore, the underlying debt securities do not have to be sold to any other market participant to obtain the required cash.

·       Ex 5.5 Provide an example of when a reverse repo is likely to occur.

o   A central bank can use reverse repos as part of implementing their monetary policy. In doing so, the central bank would borrow money from banks to control the money supply in the country.

5.5 Bonds

5.5.1 General background

·       Entity require longer-term capital -> equity or debt

·       To raise debt -> entity creates and sells (issues) a debt security.

o   In return they pay interest to the purchaser and repay the principal at the end of the term of the security.

·       Bonds -> longer-term debt securities (>365 days).

·       Coupon or coupon payment -> annual interest rate paid on a bond, expressed as a % of the face value and paid from issue date until maturity.

o   Coupon rate -> (sum of coupons paid in a year)/(FV of the bond)

·       Bond investor has an initial –ve cash outflow, followed by small known +ve CFs and a final amount at specified future dates known in advance.

o   They can sell the bond before the end date -> actual yield will be different to expected.

o   When holding long-term securities, pricing fluctuations each day might be significant short term -> which can be higher or lower than cash rate or inflation and may even be negative -> difference between return and current yield to maturity (gross redemption yield)

·       CFs of bonds is known in advance in absolute terms or by reference to some benchmark or event (in monetary terms) at the point of entering the agreement.

o   Conventional bonds -> payments fixed in monetary terms.

o   Bonds can be linked to inflation or short-term cash rates.

·       But there is still uncertainty on credit risk of the issuer -> probability that the issuer will default on some or all of agreed interest or capital payments at maturity.

·       Bond investor has provided a leverage to the bond seller -> borrowing will increase the leverage of the borrower -> greater risk of default.

o   Bond investor receives at most what has been contractually agreed.

o   If seller invests the loan in a business venture and is successful, the profit is not shared with the investor.

·       Bond is issued in primary market and traded in secondary market. Can be traded through bond markets, stock exchanges or via private placements.

·       Quoted prices in the secondary market excludes next coupon payment -> flat price or clean price. Purchaser pays flat price + accrued interest at the settlement date.

o   Dirty price -> sum of clean price + accrued interest

·       Three options:

o   Callable bonds (redeemable bond)

§  Issuer may redeem before it reaches the stated maturity date

§  Allows issuing company to pay off their debt early

§  May happen if interest rates move lower -> allows the business to re-borrow at a more beneficial rate

§  Has more attractive interest rate or coupon rate -> to compensate investors for the risk of redeemed at a time unfavourable to them

o   Puttable bonds

§  A debt instrument with an embedded option that gives bondholders the right to demand early repayment of the principal from the issuer.

§  Incentive for investors to buy a bond that has a lower return

§  Can be exercised upon the occurrence of specified events or conditions or at a certain time or times

o   Convertible bonds

§  Corporate debt security that yields interest payments but can be converted into a pre-determined number of common stock or equity shares.

§  Conversion can be done at certain times at the discretion of the bondholder.

§  Hybrid security -> price is sensitive to changes in interest rates, price of the underlying equity stock and the issuer’s credit rating.

5.5.2 Bond returns

·       In general,

o   returns to the investor come from the contracted cash flows or the sale of the securities.

o   if the issuer (borrower) gets into financial difficulties and cannot pay the contracted cash flows, the investor (lender) may be left with nothing, even though their investment ranks ahead of equity investors

o   there is no upside for the investor in terms of bonus payments or profit share if the issuer does well financially, only the contracted payments

o   Therefore, the certainty of receiving the payments (i.e. the quality of the credit) is the most crucial factor in assessing the risk of a debt security.

·       The country of issuer, listing or purchaser might affect legal action to enforce payment.

·       For a specific bond,

o   Return is determined by the value and timing of the future cash flows over the remaining life of the security to maturity

o   Risk is predominantly measured as the expected loss in the event of cash flows not being received as promised or anticipated at the time of the investment.

·       Investor can buy a debt security and either:

o   Hold the security to maturity receiving all coupons and the principal; or

o   Sell the security prior to maturity receiving none or some coupons and the sale price.

·       Returns may be different as the market price of security may change over time (unlike principal).

·       Yield to maturity or gross redemption yield -> IRR that results in sum of PVs of the CFs, discounted at this rate = current market price of the bond (if held to maturity).

o   There is a clear relationship b/w market price and market rate of return (or yield to maturity)

·       Yield to maturity is based on the following assumptions:

1.       The bond is held to maturity

2.       The issuer does not default on any of the payments -> all coupons and principal payments are received as per the original agreed dates

3.       Coupon payments can be reinvested at the same rate

·       In reality, insurers don’t hold bonds till maturity.

·       Valuation of debt securities depends on 3 factors:

o   The amounts of CFs and their timing prescribed in the contract

o   The probability of the CFs occurring -> requires credit analysis

o   The appropriate rate of interest to use to calculate PV of the CFs as determined by market forces (yield to maturity can change at any time)

·       Factors that affect the yield to maturity on bonds include:

o   Supply of bonds (gov’t bonds) -> relates to govt’s fiscal policy.

§  If governments fund fiscal deficits through the issuance of bonds, then bond yields at those targeted durations will rise as prices will need to fall to tempt buyers (increase supply to lower the price)

§  E.g. gov’t decides to switch to issuing inflation-linked bonds -> decrease in supply of conventional bonds -> price increases -> yields will fall

o   Demand for bonds -> arises from private and institutional investors

§  Institutional demand may change depending on savings patterns as a result of gov’t policy

§  E.g. 2020 early withdrawal of super -> superfunds selling more liquid assets such as bonds, increasing supply to the secondary market.

§  gov’t relaxes the need for insurance companies to hold bonds -> demand may fall.

§  Gov’t imposes compulsory annuitisation on work-based pension savings -> increase demand for gov’t issued bonds and high-credit-rated bonds.

o   Issuing organisation

§  Each have different credit ratings -> affects the demand for these bonds due to marketability or liquidity of an issue.

§  Credit risk (probability of payment) and liquidity risk (difficulty of selling before maturity) changes by organisation.

§  E.g. credit risk -> default by issuer where sovereign governments have been known to default on government bonds from time to time.

§  Use credit ratings to place a value on the risk of default.

§  Lower the credit rating -> investor would expect a higher margin over the risk free rate -> devalues the security.

§  Credit spread -> the difference in yield between two securities of the same maturity but different credit quality.

·       Credit quality assessed against that of a flagship government security (e.g. US treasure bond) which is risk free.

·       The difference in yield is quoted in basis points (1% is 100 basis points).

·       It indicates the additional return that the buyer is seeking in compensation for the credit risk assessment of the issuer.

o   Expected inflation

§  Conventional bonds are exposed to this

§  Past data show long periods where interest rates are above inflation.

§  They set an expected margin for risk-free interest rates above price inflation.

o   Uncertainty of inflation

§  Investors add margin to reflect the uncertainty.

o   Exchange rate

§  In the long run, changes in the price level in one country will cause changes in nominal exchange rates, thus keeping the real exchange rate constant. This suggests a link between long-term bond yields across similarly rated countries.

o   Taxation

§  Taxation of bonds will affect demand.

§  E.g. coupons taxed as income and proceeds taxed as capital gains/losses. If the tax rates between income tax and CGT are different -> it will affect the demand for high or low coupon bonds.

o   Return on US bonds

§  This is due to the size of US market -> all bonds are priced in relation to them

§  Pricing model is a 2 staged process:

1.       The risk-free real rate in the US Treasury market reflects the supply and demand of global capital.

2.       The nominal risk-free government rate in other countries is priced off the US rate plus local factors of exchange rates, inflation expectations, economic factors, and political stability.

3.       Credit assessment of the various issuers (both government and non-government) leads to various appropriate credit risk premiums, defined as a percentage per annum additional to the yield on the risk-free (US) government bond of a similar maturity.

§  Global rate is long-term rate -> local central bank has little control of

§  Floating exchange rate -> If the local central bank sets the cash rate too high (in the eyes of the global market), then foreign investors will demand more local currency and the exchange rate will appreciate, reducing international competitiveness. The reverse applies for a cash rate that is too low.

§  Nominal interest rates are driven by inflation and growth expectations (short and long ends of the yield curve).

§  Assume that observable gov’t bond yields are a proxy for the unobservable risk-free rates.

§  Nominal risk free yield = risk free real yield + expected future inflation + inflation risk premium

§  Short end -> local CB changes the cash rate affecting its monetary policy -> it will lift rates if the economy is expanding too quickly and lower if it is too sluggish.

§  Long end -> erosion of purchasing power (inflation). A fixed interest investor receiving fixed coupons and principal in the future has lower real cash flows if inflation should increase. Then the other investors will try to push yields up to compensate for this erosion of purchasing power. Long-term yields are very sensitive to inflationary expectations.

Interest rate risk

·       Quantitative measures of interest rate risk: Duration and Convexity

·       Duration:

o   Measures the weighted average time to receipt of cash flows, the weights being the present value of cash flows.

o   The duration, D, say, of a cash flow sequence {Ct}, using a constant rate of interest i, say, is: 

where v = 1/(1+i) and P represents the price of the CFs.

o   The modified duration, D*, say, is:

-> measure of the sensitivity of the price of the security to a change in interest rates.

·       Convexity

o   Proportional second derivative of price with respect to yield.

o   Combining duration and convexity -> good approximation of the price-yield relationship.

o   Convexity is a measure of the curvature, or the degree of the curve, in the relationship b/w bond prices and bond yields.

o   Shows that duration of bond changes as the interest rate changes -> convex

o   Used by portfolio manager to measure and manage the portfolio’s exposure to interest rate risk.

·       Taylor’s theorem -> show how convexity aids duration.

o   Let P(i) denote the price of bond at rate i.

o   For small, or sudden, changes in interest rates, duration will indicate how bond prices will change.

o   Convexity is a better measure for assessing the impact on bond prices when there are large fluctuations in interest rate

·       Duration and convexity have their limitations as risk measures, due to:

o   The inherent assumptions about the yield curve shape and yield changes;

o   The features of particular debt securities, including embedded options and interest sensitive cash flows.

·       Duration and convexity are measures of sensitivity of bond prices to shifts in yield, rather than measures of the probability of loss.

Relationship between characteristics and price

·       Price of a fixed rate bond will change whenever the assumed yield changes.

·       Relationship between the price of an instrument and the yield:

o   Price is inversely related to the yield. As the yield increases, the price will decrease and vice versa

o   Given the same coupon rate and time to maturity, the absolute change in price is greater when the yield decreases compared to when it increases — the convexity effect

o   Given the same time to maturity, the absolute change in price is greater for a bond with a lower coupon than a bond with a higher coupon when the yields change by the same amount — the coupon effect

o   For bonds with the same coupon rate, a longer-term bond has a greater absolute change in price than a shorter-term bond for the same change in yield — also known as the duration or maturity effect).

5.5.3 Conventional government bonds

·       Sovereign gov’ts issue a variety of conventional bonds with different redemption dates and coupon rates.

·       Conventional -> refers to payments in nominal terms (monetary terms)

[SYSTEM T] used to determine the risk and return characteristics.

·       Security:

o   Often has very small or negligible risk of default for bonds issued by major sovereign gov’ts -> risk is nil if it controls fiat money.

o   Security in monetary terms is usually high.

o   But sovereign gov’ts can default

·       Yield:

o   Known at outset in monetary terms (if it is held till redemption and all coupons are reinvested at expected rate)

o   Inflation adjusted return (real return) is unknown at outset as rate of inflation is unknown.

o   Running yield = expected income over 1 yr/ current price -> difficult to compare against equities in recent years because of significant market swings.

o   Total return is secure in nominal returns and this may lead to the conclusion that it should be lower than more risky investments -> but nominal return has a risk of inflation and consequent erosion of real return.

·       Ex 5.6 Describe two scenarios where conventional bonds perform well in terms of the return achieved for the risk that is borne.

o   When yields reduce, as prices will increase

o   When inflation was lower than anticipated

o   When other asset classes perform poorly.

·       Spread

o   Affected by supply and demand factors

o   Spread (compensation for credit risk) is small for gov’t bonds.

·       Term of government bonds

o   Varies from one year to undated bonds (perpetual bonds).

o   Varies by market

·       Expenses

o   Very low

·       Exchange-rate risk -> only if the loan is not in the investor’s domestic currency

·       Marketability and liquidity

o   Excellent for gov’t bonds

o   Low dealing costs

o   Large volumes of bonds held and traded by institutional investors

o   Liquidity -> assisted by an active market in derivatives based on bonds and by a market that decomposes a bond to its components (STRIPS)

o   STRIPS -> Separate Trading of Registered Interest and Principal of Securities.

§  Zero coupon bonds -> pay no interest or coupon

§  Created when a bond’s coupons are separated from the bond

§  Then the bond is sold to an investor at a discount price with no coupons (no need to reinvest the coupons at a lower rate)

§  Each coupon payments also become a zero coupon bonds that can be sold separately

5.5.4 Corporate bonds

·       Issued by corporations to raise capital.

·       But to trade in capital market -> should meet minimum capital requirement and credit assessment.

·       Corporate bonds may be secured (debentures -> unsecured) against assets of the corporation or unsecured.

·       Conventional debt ranks ahead of shareholder equity.

·       Some debt securities have options that allow borrower to convert it to shareholder equity rather than repay the principal.

·       Corporate bonds have higher yield compared to gov’t bonds -> for additional credit risk and lower liquidity (marketability).

·       Yield to maturity for corporate bonds:

o   Yield = required risk free real yield + expected inflation + bond risk premium

o   Bond risk premium’s main components:

§  Inflation risk premium -> additional compensation for uncertainty in the risk of future inflation

§  Credit default premium -> for risks that the bond issuer will default on payments

§  Marketability premium -> for the risk the bond can’t be resold before maturity

·       Ex 5.7: Use SYSTEM T to detail the investment and risk characteristics of:

o   Money market instruments

§  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.

o   Corporate bonds

§  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

·       higher yields to allow for marketability and default risk.

§  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 flat and capital gains are limited (if the bonds are held to maturity). For this reason, income levels tend to be higher, compared with equities or property.

§  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

·       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 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.

5.5.5 Inflation-linked securities

·       Has coupon set as a margin over a specific index, typically CPI.

·       This margin is referred to as real return or real yield -> specified in the contract

·       E.g. Australian gov’t issued inflation-linked bonds -> nominal amount of security is adjusted for CPI each quarter. Lagged by one quarter based on average of previous two.

·       Interest based on the adjusted nominal FV (indexed value) x fixed coupon (margin) and is normally paid quarterly. On redemption, adjusted capital value (indexed) is paid.

·       Calculation is complicated. Investors assume income and maturity payments are adjusted for inflation.

·       Indexed bonds are traded on ‘real’ yield (return above inflation) basis, convertible quarterly -> formula similar to fixed coupon.

·       Real return is known (if held to maturity) and is valuated based on the assumptions that the reinvested rate has the same margin as the coupon rate, but inflation index returns are not known in advance.

·       No lags between coupon payments and underlying inflation index. But in practice there is -> it limits an index-linked security’s ability to hedge inflation risk as the CFs do not related to the inflation index at the time of payment due to delays in calculating the index. Also sometimes the issuer wants to know the payments in advance too -> end up using index from earlier period.

·       Purchasing power diminishes over time due to inflation -> investors are attracted to a security with interest and capital that are not fixed but linked to index.

·       Real yield on bonds is used as a benchmark for equities.

5.5.6 Floating rate notes

·       Is a non-conventional bond -> known as floating rate bond or adjustable rate bond.

·       Pays a coupon that is determined as a reference rate + specified margin. Interest paid quarterly.

·       E.g. bank bill rate + 1.5% pa. In AU -> margin is over the bank bill swap rate (BBSW)

·       The margin is set by the issuer (in response to market appetite reflecting credit risk) at the time of issue and is not changed. Lower margin -> lower risk (stronger credit assessment).

·       Interest is not adjusted in accordance with market movements of the reference rate (usually cash rate), the capital is not as sensitive to overall movements in interest rates as a fixed coupon bond.

·       Adjustable rate bond with a longer term to maturity may be sensitive to movements in the market’s expectation of an appropriate margin over the reference rate.

·       Factors affecting pricing:

o   Demand for funds

o   Changes in Credit quality assessment

o   Short term rate movements -> due to the reset mechanism on the payment dates, FRNs will pay a fixed rate until the next coupon reset date. Therefore, an investor is locked in at the current rate until it resets at the next reset date.

o   Accrued interest -> as a note gets closer to the interest payment date, it builds up more accrued interest and its price, all other things being equal, will rise. When the interest is paid, the price will fall by the amount of the payment and will again start to accrue interest on a daily basis until it is paid on the next payment date. The same is true of fixed rate bonds.

·       Because of the way they are structured, FRNs typically protect a portfolio when interest rates are rising -> central bank increase cash rate to slow growth in an economy, FRN income will also increase with the cash rate. Hence, FRNs are less exposed to a decline in price than fixed rate bonds under those economic conditions.

5.6 Term structure of interest rates

5.6.1 Spot and forward rates

·       Bonds are often more straightforward than equities because of the relative ease of valuing the securities.

·       The yield to maturity for a bond represents a single statistic that belies the underlying complexity of yields to different points in time. The phrase “term structure” is reference to any summary of this complexity that conveys how interest rates vary by term.

·       Yield curve -> curve fitted to plot yield to maturity against term to maturity for similar credit rates securities.

o   E.g. one may construct a yield curve from yield to maturity for the various government bonds in issue in a country. The curve is smoothed so that an individual bond’s yield to maturity is unlikely to lie exactly on the yield curve.

o   Yield curve is not static and changes in response to market conditions.

o   The shape of the yield curve -> represents term structure of interest rates

·       Theoretically, the yield curve should be analysed bonds with same properties such as currency, credit risk, liquidity, tax status (other than time to maturity -> only reason for difference in yield) and same coupon (same reinvestment risk).

o   Annual rates -> quoted for same periodicity (freq of coupons).

·       These assumptions rarely hold in practice.

·       Calculate the price of a bond based on a sequence of yields (spot rates) that corresponds to CFs dates -> assesses yields and reflects inherent risk and uncertainty with each CF.

o   Spot rate today for a specified period = yield to maturity expected to be earned with zero-coupon bond of that period (no-arbitrage value approach) -> reflects the term structure of interest rates.

·       If the price at which the bond is trading is different from no-arbitrage value -> a trading opportunity exists as it is (theoretically) possible to construct the same cash flows using zero- coupon bonds, which will have a different price (ignoring transaction costs).

·       Spot yield curve -> data sets of yields to maturity for a series of zero-coupon government bonds, with a range of maturities, can be used to demonstrate the term structure.

·       The spot curve (or zero or strip curve) is a sequence of yields to maturity on zero-coupon bonds.

·       Gov’t bond spot rates are interpreted as the risk-free yields (default risk). There are also inflation and liquidity risk to the investor.

The observed

spot rate yield

from today (t=0) for a period of n years from now (t=n) as

yn

. The corresponding

price Pn

, say, is:

·       We can observe spot rates today but not those that apply in future times. E.g. one-year spot rate is y1 but one-year spot rate in one year’s time is unknown.

·       The future (unknown) one-year spot rate from time t= s-1 to time t = s as rs. Apart from r1, which equals y1, rs is unknown today as future interest rates are uncertain.

o   Forward rates are derived from spot rates as the break-even reinvestment rate. They bridge the return on an investment in a shorter-term zero-coupon bond to the return on an investment in a longer-term zero-coupon bond.

Denote the forward rate in the period from time t = n-1 to time t = n as

fn, then:

·       Compare f2 with r2 by considering an investor who has a one-year time horizon who can receive guaranteed 1-year yield of y1.

o   Alternatively, they could buy 2-year guaranteed yield of y2 and sell at the end of year 1. If the one-year spot rate at the end of the year coincides with the expected value of r2, then the return over the first year must be y1.

o   However, there is a non-zero chance that the actual value of r2 ≥ its expected value. The one-year horizon investor would need to be tempted into the strategy of buying the two-year bond and selling it at the end of the first year. This would force up y2. A consequence is that the forward rate, f2, would then exceed the expected future spot rate, r2. Therefore, .

o   Under these conditions, the market is dominated by short-term investors, However, if the market is dominated by long-term investors, then the opposite conclusion would be drawn —that there is a relationship between forward rates and future spot rates: where liquidity premium may be +ve or –ve.

·       You can only infer the future spot rates from the current spot rates when there is no interest rate uncertainty. If there is uncertainty, the forward rates do not inform you of likely future spot rates.

5.6.2 Yield curve shapes

·       Common yield curve features:

o   upward slope

o   a concave shape — steeply upwardly sloping, then levelling out to become almost flat at longer durations.

·       Short rates are more volatile than longer-term interest rates, as the longer-term spot rates are averages of the one-year spot and forwards.

·       Shapes the yield curve can take include:

o   Upward sloping or normal

o   Flat

o   Downward sloping or inverted

o   Humped

·       Longer-dated gov’t bonds tend to have higher yield compared to shorter-dated gov’t bonds under normal market conditions.

·       Inverted yield curve – shorter dates gov’t bonds have yields higher than longer-dated ones (spot curve is downward sloping).

·       Market conditions, changing expectations, or supply and demand for particular terms to maturity can all affect the shape of the curve. E.g.

o   Regulator requirement to hold long-term bonds by insurers when they are low on supply -> increases demand -> lower yields for long-term bonds but no impact on shorter-term yields -> humped curve

o   Evidence that inverted yield curve is a reliable indicator of recessions in the USA.

o   The flat yield curve is a yield curve in which there is little difference between short-term and long-term rates for bonds of the same credit quality.

5.6.3 Theories explaining yield curves

·       Shows the factors affecting the shape of the yield curve.

·       Assist when developing interest rate risk management strategies for debt security portfolios and when developing pricing models for interest rate sensitive derivatives.

1.       Expectations theory:

·       Aims to predict what short-term interest rates will be based on long-term interest rates, which in turn are driven by expectations of future economic factors.

Pure expectations theory states that expectations alone drive interest rates -> no bond liquidity risk premium. Therefore, forward rates = future spot rates:

1.       Market segmentation theory:

·       Economic theory generally states that prices and yields are determined by supply and demand.

·       Market segmentation theory asserts that certain types of investors restrict their purchases to certain maturity ranges (segments) -> commonly divided into short-term (e.g. bank -> protect principal and maintain liquidity), medium-term, and long- term (life insurer selling annuities -> match LT annuity payments with guaranteed income streams).

·       It says that bonds of different maturities effectively trade in different markets, each with its own supply-and-demand forces that produce bond yields. Therefore, yields from one group of bonds with a certain maturity length cannot be used to predict the yields of another group with a different maturity.

·       The supply and demand in different segments lead to time-varying risk premia, which may be positive or negative.

·       The yields for each segment are therefore driven by the demand and supply in that segment and each segment can have a different shape — so the overall yield curve may be quite different from what the other theories suggest would be observed.

2.       Liquidity preference theory:

·       Investors prefer access to their capital through liquid investments rather than having no or restricted access, all else being equal. Thus, investors expect to be compensated for locking in their capital by receiving a higher expected return than on liquid investments (such as cash).

It claims that a positive bond liquidity risk premium exists, so that investors in longer duration bonds require a higher expected return as compensation for the extra risk borne. Thus, we have:

·       Theoretically, this liquidity risk premium increases with duration, which is proportional to the volatility of bond prices with respect to yield (consisted with modern financial economic theory).

·       There is some empirical evidence that this bond risk premium varies over time, particularly with economic conditions.

·       The theory says that longer-dated investments are seen to be less liquid than short-dated investments -> yields are expected to be upward sloping.

1.       Inflation risk premium theory

·       Inflation risk -> risk that the purchasing power of capital gets eroded if returns (capital growth) are lower than inflation.

·       According to this theory, this risk is more likely to occur over longer periods, so inflation risk premium theory suggests that the yield curve should slope upwards to compensate for longer-term investments, which are more susceptible to inflation risk than shorter-term investments.

 ·       These theories are not mutually exclusive as they can coexist to some degree.

 ·       It is difficult based on empirical evidence to endorse one theory above another because:

 o   it is difficult to broadly measure consensus expectations

o   interest rate changes can be surprising rather than predictable

o   measurement of liquidity premia is difficult in the face of uncertainty and when premia may change over time

o   more than one theory may be consistent with an observed yield curve.

 ·       The lack of consensus and relatively inconclusive evidence for any one theory presents a challenge for the actuary when developing assumptions about future bond yields. Even an assumption to apply a positively shaped yield curve could be challenged.

5.7 Key learning points

•         Debt securities carry their own jargon and you need to be familiar with the main terms used.

•         As there is a wide array of debt securities, be able to discuss the characteristics of the main types.

•         The yield to maturity is the internal rate of return from the cash flows of a debt security, using the current price and assuming that all agreed cash flows are received.

•         A spot rate today for a specified period is the yield to maturity expected to be earned when holding a zero-coupon bond for a specified period.

•         Forward rates measure the marginal return earned for extending an existing investment in a zero-coupon bond to a longer term.

•         The main shapes that the yield curve can take are:

–         upward sloping, or normal;

–         flat;

–         downward sloping, or inverted; and

–         humped.

•         The three main influences on the yield curve shape are (in order of importance):

–         expectations of future rate changes;

–         bond risk premia; and

–         convexity bias.

•         The main theories of the yield curve shape are:

–         expectations theory

–         market segmentation theory

–         liquidity preference theory; and

–         inflation risk premium theory.

•         The yield curve is typically not very smooth, due to the relative supply of securities along the term-to-maturity spectrum. However, a smooth curve is often fitted as a model of the yield curve.

•         The spread above the risk-free yield curve for a particular issue is a function of:

–         credit risk;

–         general economic conditions and the differential impact on the issuer;

–         remaining term to maturity;

–         liquidity; and

–         relative supply of different securities.

 Tutorial 3

Discuss the

features of corporate debt

that would make it a suitable investment for a scheme providing benefits on retirement.

The scheme will wish to choose assets that are the most appropriate for its liabilities.

•         As benefits are provided on retirement, the timing of payments is reasonably predictable, and overall for an open scheme there will be a long time frame (as members aged 25 to 65 say).

•         If benefits are defined benefits (in terms of salary and service) then the value is reasonably predictable as well.

•         If benefits are defined contribution (contributions plus earnings) then the benefit value will reflect the scheme’s investment earnings and potentially the member may direct the investment choices.

•         Term/yield: Range of available terms. May be able to select CB with maturity dates aligned to scheme’s expected lump sum payment outflows; or coupon payments aligned to annuity payments. That is, may be able to select bonds to match, at least partially, the liability payments.

Especially helpful if scheme is closed to new entrants and running down to last payment or running a closed annuity book

•         Real return: Nominal bonds have predictable returns which may be helpful in itself as above but no inflation protection; Indexed bonds ensure values increase with inflation which will assist in matching salary increases for the scheme.

•         Security: Reflects underlying issuer, in developed countries with strong government rating and issued by larger corporations could be close to risk free. CB with strong credit ratings ensure scheme has good capital protection and is therefore able to pay benefits when due.

•         Volatility: Price volatility lower than equities, although higher than government bonds. Scheme may have to meet minimum funding/solvency targets so lower volatility is helpful

Diversification benefits (compared to government bonds) as we expect:

o   higher yield for additional credit risk;

o   higher yield for reduced liquidity; and

o   scope for active management.

Diversification benefits (compared to equity):

o   predictable cash flows (coupon) compared to dividends;

o   lower volatility in returns; and

o   priority over shareholders for return of capital in event of corporate failure.

•         Tax: Reflects jurisdiction, needs to be taken into account when considering net returns. May be tax payable on income, on capital gain or on neither.

•         Capital gain: limited capital gain if held to maturity; successful active trading of a CB portfolio may generate capital gains for the scheme.

List the factors that influence yield differences between government and corporate bonds.

•         marketability / liquidity

•         supply and demand

•         credit quality (of issuer and particular issue)

•         corporate prospects (of issuing company)

•         forecast strength of economy

•         available terms

•         restrictions on investors

•         corporate may be convertible

Describe the possible features of a new corporate bond issue that would reduce the risks associated with it.

•         Floating charge over all or some assets of company

•         Fixed charge over a given asset

•         Collateral provided

•         Financial covenants e.g. income cover

•         (No) prior ranking debt

•         Rights in a technical default

•         Restrictions on further borrowing / equity distribution

•         Parent company guarantees

•         Third party guarantees

•         Shortening the term

•         Increasing size of issue

ALM 2020 Exam Q1

(b) State the arguments in favour of adding international assets to this diversified portfolio.

•         Arguments in support of international assets are primarily around increasing the diversification of the portfolio

•         By accessing industries not available in home country

•         Access to countries with different local expectations for market risk/return – there may be undervalued markets for example.

•         Exposure to other currencies and movement in exchange rates, which may be favourable

•         Added diversification by exposure to markets in different stages of economic cycle

•         Access markets with low correlation to local market for risk/return although this is less likely now with global economic forces

[sfactuary]

Asset Liability Management

•         

3.    CAPITAL MARKETS

4.1 Overview

•        Capital markets are the part of a financial system that is concerned with raising capital by issuing debt and equity (the primary market) and subsequent buying and selling of assets (the secondary market).

4.2 Types of asset classes

•        Assets are affected by factors such as long-term return, risk (including volatility), liquidity and protection against inflation.

•        Key concept: categorise groups as homogenously as possible in order to apply some form of averaging to gauge what we may expect to happen in the future.

•        Asset class: category of investments that exhibit similar characteristics in the marketplace.

•        Asset is a resource, owned by a company or individual, which has future economic value that can be measured and can be expressed in currency.

•        Categories of assets

o   Physical assets – generate rent or outputs that can be sold

o   Debt – borrower returns the amount loaned with interest

o   Equity – ownership of an enterprise and resulting profits are shared

o   Hybrid securities – combination of debt and equity (e.g. convertible bonds, preference shares)

o   Derivatives of real assets

o   Securitised assets – were originally illiquid assets but have been repacked as liquid assets (e.g. collateralised debt obligations)

•        Category of investments – suggests there are significant number of clearly investible assets in the universe of obtainable investments. E.g. shares from large corp in well-developed economy with readily investible via stock markets. Some assets (e.g. national parks) are not investible, other assets (e.g. small franchises) are too small to be investible by third parties

•        Similar characteristics may require the components of an asset class to:

o   Have similar risks and returns

o   Perform in a similar manger in certain market conditions

o   Be subject to the same laws and regulations

•        Investments in different assets classes should

o   Have different risk and return characteristics

o   Perform differently in similar market conditions

The returns should be different as well. E.g. foreign shares behave diff to Australian shares, but 10 or 9-year gov’t bonds behave very similarly and should be combined into one asset class.

•        Financial theory suggests that by investing in more than one asset class investors can diversify their investments and reduce risk while maintaining an overall target return.

•        Individual assets within an asset class do not always move in same direction. E.g. rise in oil prices are good for oil companies but not to airlines; rise in consumer expenditure would be similar so they are part of the same asset class.

•        Investment – creates wealth. Investment in an asset class should have return for the risk taken.

•        Futures contracts and other zero-sum derivatives are not of themselves valid asset class, but with underlying assets, they can be useful to manage a portfolio.

•        Asset classes are divided in to:

o   Defensive – or income classes are debt classes

o   Growth – those with element of equity (i.e. ownership of a property or enterprise)

•        Alternative assets such as private (unlisted) equities, infrastructure loans and hedge funds.

o   Hedge funds usually have the ability to take short positions as well as long positions

•        Sector investments – refers to a sub-set of an asset class e.g. banking industry sector within equities

4.3 Capital market considerations

4.3.1 Cash deposits

•        Are short-term debt instruments where the investors can have access to the funds placed on deposit often at short or little notice.

•        Notice periods can range from instant access to deposited amount to no access for a fixed term (penalty may apply).

•        Interest might vary on the deposits e.g. variable, fixed for a period or extreme fixed for the entire terms of the deposit.

•        Cash flows can be specified in advance if its fixed term deposit with fixed interest but not for call account, with instant access, earning variable interest.

•        Reflection: Considering a client’s goals, what would be the most suitable terms for placing cash on deposit for an investor who needs to pay university fees for their child in the next year? (Hint: Consider the nature and timing of the payments.)

o   With an instant access account, you or your child can withdraw or deposit money at any time. Normally, you get a lower rate of interest than with other account types.

o   Regular savings accounts are designed to encourage children to save an amount every month, and often run for a set amount of time, for example 12 months. If you withdraw within that time the account might reduce the interest you’ll get. These accounts usually pay a higher rate of interest than instant and easy access accounts as a result.

4.3.2 Debt markets

•        Debt securities (debt instruments) have initial purchase price (i.e. investment amount or amount loaned) followed by an expectation that at least or a series of CFs will be received in the future (timing specified in advance).

•        Short-term money market is primarily made up of debt securities with <365 days

•        Long-term debt securities – bonds – have agreed schedule (amount and timing) of interest repayments (coupons) with fixed rate or an index-linked rate.

•        Bonds’ typical categorisations are:

o   Gov’t bonds – listed in local market

o   Corporate bonds – listed in local market

o   Overseas gov’t and corporate bond markets listed in foreign markets

•        Fixed interest bond – investor pays a fixed amount (i.e. –ve CF) at the start and then receives a series of regular level interest payments followed by a final repayment of principal (i.e. capital/ redemption amount). They are predictable -> investor can determine the return on their investment.

•        There is credit risk for bond holder depending on the issuer of the bond

•        There is liquidity risk if the bond is sold before maturity date

•        Bond price can be calculated by discounting future CFs and is driven by the yield curve.

4.3.3 Equity markets

•        Investor is taking ownership of a business and shares any profits/loss and if business fail, is last in line for RoC after all other creditors.

•        Common equity investment – shares of listed companies in public stock exchange. This protects public investors as they would need to meet certain standards to comply with the stock exchange’s requirements for being listed.

o   Being listed also provides a secondary market for trading shares and liquidity for the investment as well as easily attainable market values for the shares

•        Price of a share reflects supply/demand for it and underlying value of the business.

•        Equity prices reflect company operations, future expectations and the environment in which companies exist. Therefore, same industry -> experience similar share price movements.

o   Classifications are often by industries with major equity markets having separate indices that track the performance of these sectors.

•        Reflection: Considering the key differences between debt and equity investments, propose investor objectives that would lead to investment in each class. (Hint: Consider both risk and return characteristics.)

o   Debt investments, such as bonds and mortgages, specify fixed payments, including interest, to the investor. Equity investments, such as stock, are securities that come with a "claim" on the earnings and/or assets of the corporation. Common stock, as traded on the New York or other stock exchanges, is the most popular equity investment. Debt and equity investments come with different historical returns and risk levels.

o   Debt investments tend to be less risky than equity investments but usually offer a lower but more consistent return. They are less volatile than common stocks, with fewer highs and lows than the stock market. The bond and mortgage market historically experiences fewer price changes, for better or worse, than stocks. Also, should a corporation be liquidated, bondholders are paid first. Mortgage investments, like other debt instruments, come with stated interest rates and are backed up by real estate collateral.

o   Fortunes can be made or lost with equity investments. Any stock market can be volatile, with rapid changes in share values. Often, these wide price swings are not based on the solidity of the organization backing them up but by political, social or governmental issues in the home country of the corporation. Equity investments are a classic example of taking on higher risk of loss in return for potentially higher reward.

o   Debt instruments, whatever they may be called, are corporate borrowing. Instead of procuring a straight commercial bank loan, the organization "borrows" from a variety of investors. This is why debt instruments, such as bonds, come with a stated interest rate, as a loan would. Equity investments offer an ownership position in the company. Owning stock makes the investor an owner of the organization. The percentage of ownership depends on the number of shares owned as compared with the total number of shares issued by the corporation.

o   Investing targets may favour equity investments, if you're seeking striking growth or profit potential. Conversely, you might focus on debt instruments when you prefer consistent income and less risk. Tailor your investment actions to match your objectives and risk tolerance.

4.3.4 Property markets

•        Investors ultimately acquire ownership of land and buildings.

•        Return = rent – expenses + capital appreciation, which may be –ve

•        Investors can purchase property directly or indirectly, via a pooled investment fund (e.g. listed vehicles called Real Estate investment Trusts) or shares in a company operating in the property sector.

•        Institutional investors and pooled investment funds are able to purchase individual properties that are beyond the budget of retail investors.

•        Indirect investments are good if they cannot buy (e.g. lack of sufficient capital) or might not have had the appetite (e.g.  risks and low levels of liquidity) with direct property investments. Covers range of properties and improve liquidity with high correlation to listed markets.

•        Property investments have idiosyncratic risk (i.e. specific and unique to the individual properties) and the characteristics of the actual properties can also vary tremendously within the asset class.

o   Single property investments – large and indivisible, which influences marketability and liquidity.

o   The ability to generate income depends on the quality of the tenant and this exposes the investor to risks such as vacancies and rental arrears. Investors also face the risk of buildings becoming obsolete, reducing rental income, slowing growth rates, and requiring modernisation over time. Another risk is political risk (e.g. government intervention such as rent controls) as residential property in particular is a politically significant and sensitive asset class.

•        Property valuations – subjective, matter of professional judgement. Price discovery is limited to when the property is traded and usually confidential. Underlying assets are also heterogeneous which makes valuations harder.  

o   Listed prices are volatile and influenced by market factors.

•        Reflection: For a superannuation fund with total assets over AUD$50 billion and a 15% allocation to property assets, weigh up the merits of direct and indirect property investments.

o   ADVANTAGES OF DIRECT INVESTMENT

§  Greater potential for capital appreciation. The goal is to make money.  Direct real estate offers the best means of maximizing returns through greater potential capital appreciation from increased property values captured when properties are sold.

§  Better tax benefits. The goal is to shelter one’s income once one has earned it.  Direct real estate offers the best shelter through greater tax benefits.  Unlike REITs, direct investments can pass through tax losses, which may then be used to offset taxable gains.  Direct real estate investment can be particularly appealing to accredited investors.

§  Superior portfolio diversification.  The goal is to protect one’s assets through diversification.  Direct investment offers the best diversification benefit. While REITs are commonly marketed as having a low correlation to the stock market, direct investments have an even lower factual correlation.

§  The advantage of owning a property outright and not in partnership with anyone is that it is yours and you can gear up to 100 percent of the investment (which means you own property without equity).

§  You earn the future rewards of that property and have 100 percent decision making ability on that property.

§  The disadvantage is that the risk is 100 percent yours – in terms of financial market risk (interest rates), business risks, and the risk of default when you have tenants.

o   Advantages of indirect investment

Indirect property investment has the following advantages:

1. Shares / Shares in funds

§  General Remarks

·         Investment with low levels of capital expenditure as well

·         Investment diversification (shares, funds, bonds)

·         No involvement in refinancing, facility management, real estate management and end-users (tenants, lessees etc.)

·         Comparability / benchmarking

·         Liquidity of participating interests » sale on the stock market

·         Improved performance / higher yields (professional real estate management and facility management

·         Performance monitoring by other investors, analysts and media

·         Income stream

§  For property companies limited by shares (listed on the stock market)

·         Property shares may be bought and sold on the stock market at any time

·         Visibility through option to publish real estate

§  For shares in property funds

·         Return option

·         Investor protection through investment rules and supervision

·         Property bond option

·         Market making opportunities for trading in shares in property funds

·         Visibility through option to publish real estate indices 2. Companies

o   Disadvantages

1. Shares / Shares in funds

§  General Remarks

·         Dependence on the professionalism of the fund management

·         Dependence on the protection of minority holdings and its effectiveness

·         Complete transparency

o   of mutlisectional structures, profit transfers possible

o   Clarification of the structures and procedures is necessary

§  For property companies limited by shares

·         Risks inherent in company purpose (no restrictions on holding and trading in real estate, e.g. additional purpose as a general undertaking or total solution provider and as a property developer [e.g. Allreal AG]

·         No investment rules (in contrast to the mutual property fund, property OEICs and property CEICs)

·         Voting shares for promoter as reason for not participating in the vehicle

·         Group-related subordination and resultant risks

·         Clarify group structure

§  For property funds

·         Cost intensity (marketing costs [portfolio management commission [also retrocessions], subject to marketing outlay], fund management fees, depository bank, real estate management and so on)

·         Liquidity issues (insolvency of unsellable real estate)

·         Shares are only taken back at the end of the financial year, every 12 months (exceptions are possible)

·         Closure of fund / compulsory liquidation

o   The differences between direct and indirect property investment?

§  Direct investment in property refers to when you buy the whole or part of a physical property. As a process, this is not as easy or as quick as investing in equities or bonds, as it requires more time and more capital.

§  As a property owner you receive rent directly from your tenant, and you can realise gains or losses from the sale of the property. As a landlord you have additional responsibilities for the management of the property. Some of these require specific and specialist knowledge, such as that held by a chartered surveyor. while

§  Indirect property investment involves investing in the skills and expertise of other people, such as property or fund managers. There are a number of different ways of investing indirectly in property (see the ‘How can I invest in property?’ section). One of the most common routes into the property market, particularly for commercial property, is through collective investment schemes (such as property funds), where investors’ funds are pooled together.

§  Investors need to be aware that making indirect investments is likely to mean the performance of their investment vehicle is not wholly related to the performance of the property or properties contained within the vehicle. In addition, the tax treatment of indirect investment vehicles may be an issue. You need to be aware of the risks involved, and you should always seek financial advice where required.

4.3.5 Derivatives

•        An instrument with its value dependent on the value of another security or instrument

•        Some provides an option to exercise a right, others place an obligation on the investor to proceed with a pre-defined agreement.

•        Forward contract – an investor agrees to buy (or sell) an asset at a specified price and specified date in the future. Has counterparty risk of not fulfilling each parties’ obligation as part of the agreement.

•        Futures contract – investor agrees to buy (or sell) an asset at a specified price and specified date in the future. Unlike a forward contract, is standardised and can be traded on a recognised exchange.

•        Long position in an asset – holder profits from increases in the value of the asset (while losing wealth if the asset falls in value).

•        Short position in an asset – holder profits from decreases in the value of the asset (while losing wealth if the asset appreciates in value).

o   For forward and futures contracts, the party having the long position has entered a contract to take delivery of the underlying asset at a specified date in the future. Similarly, the party holding the short position has entered a contract to deliver the underlying asset at a specified date in the future.

•        Options – provide the option buyer with the right, but not the obligation, to buy/sell the underlying asset at a specified date in the future.

o   The option seller (i.e. option writer), has an obligation to transact if the option buyer decides to exercise their right under the agreement. The price paid by the option buyer to the option writer for having this choice is called the option premium.

•        Call option – holder (with long position) the right, but not the obligation, to buy a specified asset, at a specified price, on a specified date or dates in the future.

•        Put option – holder (with a long position) the right, but not the obligation, to sell a specified asset a specified price, on a specified date or dates in the future.

•        Strike price (exercise price) – price at which the underlying asset can be bought from (under a call option) or sold to (under a put option) the option writer (i.e. issuer of the option).

o   Option writer always holds a short position in the security (unless they sell it to another party).

•        European option – the exercise date is only at the expiry of the option.

•        American option – an option that can be exercised at any date before expiry. In other words, ‘early exercise’ of the option before the expiration date is possible with American options, when it is considered optimal to do so.

•        Over the counter (OTC) – held directly between two counterparties. E.g. spread options, barrier options, lookback options, credit default swaps (CDS), and rainbow options.

o   They can be structured (created) and bought from investment banks, large investments firm with sufficient capital, technical and marketing expertise to run an options desk.

o   They are common when underlying asset is foreign exchange.

•        Exchange traded – have standardised features/contracts.

o   Actively traded on an organised public exchanges and are often quite liquid.

o   Common when underlying asset is an actively traded stock

•        Reflection: What are the pros and cons of entering an exchange-traded option compared to an over-the-counter option?

Parameters  of Comparison

OTC

Exchange

Definition

OTC  or over the counter is the method of trading for the companies that are not  listed formally.

Exchange  is the method of trading commodities and derivatives for the well-established  companies in an organized manner.

Operated  by

Securities  that are traded over the counter are traded through the dealer.

The  exchange is the centralized system of trading with a well-organized network  of people to ensure fair trading.

Formality  status

OTC  is the decentralized and informal setting for trading which is usually used  by small companies and businessmen.

Exchange  is an absolute formal setting of trading done by well-established companies  to keep constant supervision on the action.

Work  hours

It  can be operated at any time because it is done through the dealer.

This  works according to the exchange timings and not the entire day because it is  the intricate network.

Defined  Location

For  trading through OTC one can make use of phones and laptops and can connect  from anyplace.

Exchange  is the formal setting that has a physical location to be operated from.

OTC market is decentralized for the unlisted companies and can be operated from anywhere such as emails, phones, telephone lines, etc there do not need any specific physical location to operate. There is no formal exchange in this market.

There are some advantages and limitations to this method of trading. Some of the advantages are listed as follows:

It is a low-cost trading method where investors     can earn significant returns.

Due to fewer obligations many companies at a time     can be listed on the trade list.

OTC provides access to securities that are     otherwise not available on a formal exchange.

Some of the limitations of OTC are mentioned as follows:

It has less trade liquidity and transparency     which can often create issues for the investors.

Fewer regulations and centralized structure make     it prone to fraud and outdated information.

OTC traders tend to take volatile actions on the     release of economic data.

 Exchange is the marketplace where commodities, derivatives and financial instruments are traded. It is done formally to ensure liquidity and fair exchange of commodities among the traders.

Exchange is a centralized method of trading for well-established companies to raise their capital. An exchange may be a physical location where traders meet to conduct business or can be called an electronic platform.

Some of the examples of exchanges can be the New York Stock Exchange and the Bombay Stock Exchange. They operate on a large scale and work with several rules and regulations. 

Some of the advantages of Exchange can be:

It is a formalized structure therefore it     maintains transparency and liquidity of the investors and trading system.

A stock exchange is used to raise the capital of     the companies that seek to grow and expand their operations.

 OTC (over the counter) and Exchange are different methods of trading in a marketplace. When the trade happens between the two parties through a dealer then it is known as over the counter trading whereas when it happens between multiple traders in a transparent form then it happens through an exchange.

Exchange is the formalized and centralized method of conducting trade whereas OTC is a decentralized and informal method of performing the trade. There are no rigid rules and obligations when the trade happens through OTC while Exchange involves providing information publicly and fairly.

Exchange is the trading method for the well-established companies to increase their capital whereas OTC is used by small businessmen and companies.

  4.3.6 Overseas markets

•        Ex 4.1 List the main reasons why an investor might want to invest in overseas markets.

o   to increase the level of diversification and therefore reduce risk

o   to match liabilities that are denominated in the foreign currency

o   to increase expected returns

•        Primary reason for investing in overseas markets would be the risk and return characteristics of the overseas investments and how they compare to the performance of the local portfolio.

•        Lower the level of correlation between the countries invested in, greater the diversification benefit. Diversification can also be supported through investment in industries that are not necessarily available in the local capital markets.

•        Returns vary based on inefficiencies within the market or to compensate investors for perceived higher levels of risk in some overseas markets. This enables asset managers to find undervalued markets and investments.

•        Challenges for investing in overseas markets (overcome by hedging currency risk):

o   Investors with local liabilities will need to accept mismatch in currency between their assets and liabilities.

o   Exchange rates can be more volatile than market volatility.

o   Costs associated

o   Repatriation of funds

o   Withholding taxes

o   Barriers to entry – can make it less attractive to invest in foreign markets

•        Costs are driven by factors such as:

o   Having the necessary resources with the appropriate knowledge and skills to analyse the overseas counties and economies

o   New systems, processes, and procedures to deal with foreign investments and the administration as well as operational aspects associated with the investments

o   Appointing a separate or sub-custodian with a presence in the foreign market

o   Political risks (foreign investing in China/South America is different from foreign investing in the US)

•        Ex 4.2: List eight challenges facing an investor when considering overseas markets.

o   barriers to entry such as restriction on the (foreign) ownership of certain shares

o   political uncertainty and the risk of adverse political developments

o   greater reliance on available information — however, sometimes information is more limited compared with the home market

o   language barriers, despite many of the larger overseas markets publishing financial statements in English

o   timing differences and time delays — however, technological advancements have bridged this to a large extent in more recent years

o   different accounting standards

o   less regulation and oversight, potentially resulting in more market manipulation

o   smaller secondary markets and, potentially, less liquidity

•        Differences between overseas and domestic investment markets:

o   Taxation

o   Local regulations

o   Stability of market values and the general economy

o   Default risk and the perception of default risk

o   Anticipated as well as surprise currency movements and the impact on ultimate local returns

•        It is often suitable to invest in overseas market via indirect investments, especially for retail investors and smaller institutional investors. Indirect exposure also gives access specialist knowledge when the overseas jurisdiction or investments fall outside their own areas of expertise.

•        Indirect overseas investments include:

o   Collective investment vehicles specialising in overseas investments

o   Investing in local companies with significant trade exports – the company will be affected by their customers’ local market conditions and the share price is therefore likely to be correlated, to an extent, to those overseas market

o   Local companies that have a multinational/global footprint

o   Derivatives based on overseas market

•        Ex 4.3 What are the advantages and disadvantages of investing in multinational companies?

The advantages of investing in multinational companies are:

•        It will be familiar to deal with companies that are present in the local market

•        The companies would be expected to have done their due diligence as to where might be the most profitable overseas markets

•        The companies would be expected to have the appropriate resources with the necessary experience and expertise required for the specific overseas markets they are operating in.

The disadvantages of investing in multinational companies are:

•        The companies’ earnings will be diluted by the local market movements

•        Investors won’t be able to select and influence which overseas markets are selected as investments

4.3.7 Emerging markets

•        Are capital markets in developing countries e.g. Brazil, Russia, India, China and Singapore as they are expected to offer higher growth prospects

•        Due to nature of these markets, potential inefficiencies provide opportunities for profitable investments to be made. These markers are less correlated with the major markets and developed economies and thus provide a potential diversification opportunity.

•        These markets are not fully developed, so extremely risky. They are also smaller than major developed markets and exposed to money flowing in and out.

•        It also gives higher exposure to political and sovereign risks e.g. gov’t changing the market’s operating conditions without notice, imposing new taxes, cancelling trading licenses, devaluing currency and so forth.

•        Ex 4.4 List 10 factors to consider before investing in emerging markets.

o   language barriers and communication challenges

o   restrictions on investments from foreign investors

o   quality and availability of information

o   political stability and predictability

o   currency policy, stability, and outlook

o   liquidity and marketability

o   regulation and oversight

o   number of companies available to invest in

o   accounting standards

o   economic growth and stability

o   current market valuation

4.3.8 Collective investment schemes

There are various collective investment structures. 2 main types:

•        Open-ended fund: the issuer will always create more shares as demand continues. Managers can therefore create and cancel shares as money is invested or disinvested in open-ended funds

•        Closed-ended funds: raise a set amount of money and issue a specific number of shares. In a closed-ended fund, shares can therefore only be bought from a willing seller. E.g. Investment trust.

•        Ex 4.5 Compare and contrast the main differences between open-ended and closed-ended funds.

Closed-ended funds can invest in a wider range of assets compared with open-ended funds as fewer restrictions exist — for example, lower levels of liquidity requirements exist as shares are traded via the secondary market.

 As shares can be created and cancelled under open-ended schemes, marketability is higher (and to an extent guaranteed by the manager) for open-ended funds. In contrast, marketability of closed-ended funds can be worse than the underlying assets invested in.

 If investments are unquoted (i.e. unlisted), significant uncertainty exists as to the true level of the net asset value (NAV) per share. Assets can therefore potentially be bought at a value that is less than the NAV of the closed-ended fund.

 Open-ended funds can generally not be geared and, if so, only to a limited extent. Closed-ended funds tend to be more volatile than the underlying equity positions. This leads to the expectation of being compensated with higher returns.

 Management fees and charges are generally lower for closed-ended funds compared with open-ended funds. There may also be significantly different tax rates.

 •        Ex 4.6 List the regulatory considerations for collective investment schemes.

The regulatory considerations for collective investment schemes often cover:

o   the type and categories of assets allowable

o   use and extent of gearing permitted

o   any tax relief available

o   eligible investor classes, such as restricting investors to institutional investors.

Regulation varies by country as well as between different types of collective investment schemes.

•        Investment trust – closed-ended scheme. It takes the form of public companies with capital structures that permit loan and equity capital to be raised to manage shares and other investments. They have BoD and listed on a stock exchange with shares being traded.

o   Their objective is written into the prospectus set by BoD. It influences the investment direction and decisions made by the investment managers.

o   Investment managers manage multiple trusts, often with diff objectives, strategies and director boards

•        Unlisted unit trust – open-ended fund. It has stated investment objective, which the manager will adopt to assess their management performance. Capital structures are limited as they are not allowed to borrow against their own portfolio.

•        Trustees are appointed as fiduciaries to oversee managers’ actions and their compliance with the trust deed.

o   Fees are paid to them by unit trust managers

•        Ex 4.7: Describe the advantages and disadvantages of collective investment vehicles relative to direct investments.

Advantages of collective investment schemes versus direct investment include:

o   provides diversification regardless of the amount invested

o   costs associated with direct investment are avoided

o   relatively small holding sizes available as positions are divisible

o   provides access to specialist knowledge and expertise where the investor might not have the knowledge and expertise themselves

o   the structure can potentially provide tax benefits

o   due to the smaller holding sizes, the positions could be more marketable.

Disadvantages of collective investment schemes versus direct investment include:

o   no (or limited) control over the assets invested in

o   potential tax disadvantages if the structure is unable to optimise tax management, such as withholding tax not able to be reclaimed

o   additional management charges and fees.

Overall, collective investment schemes are more suitable for investors with lower capital sums compared to investors with large capital sums available for investment.

4.4 Main economic influences

4.4.1 Interest rates

·         Short-term interest rates are predominantly influenced by a country’s central bank’s direct or indirect intervention in money market to main a specified inflation within a range.

·         Long term interest rates are linked to inflation, demand for capital/liquidity which varies over economic cycle.

·         Interests are paid on debt funding, interest rates influences capital investments and economic activity.

·         Low real interest rates -> encourage borrowing -> encourage investment spending from companies and level of consumer spending.

·         Cutting short-term interest rates -> stimulate the economy –> increase rate of growth. But if the rates are lower for too long -> increases demand for money -> increase in money supply-> adverse effects of higher levels of inflation than desired.

·         International investors are likely to invest capital in countries that have higher interest rates with the expectation of potentially earning higher returns. –> increase in demand for the currency that offers higher rates -> increase in the exchange rate.

4.4.2 Bond Yields

·         Short-term bond yields are closely linked to money market returns. Therefore, increase in ST bond rates -> bond prices will fall and vice versa.

·         Long-term bonds, other factors can offset changes in ST interest rates. E.g. increase in short-term rates might be associated with monetary tightening -> potential downward pressure on inflation over long term. Increase in ST rates -> yield on a longer-term bond increasing by a smaller amount or even declining.

o   Higher expected levels of inflation -> higher bond yields to compensate investors (as the real value of income and capital payments for fixed income bonds are eroded by inflation).

·         Gov’t’s fiscal policy is mainly funded via taxes and borrowing via issuance of bonds. While, fiscal spending is funded via increased supply of bonds, increased yields to attract investors.

·         Reflection: Issuing Treasury bills would increase short-term interest rates and potentially put downward pressure on inflation. What would be the expectation of the impact on inflation for printing money?

If the Money Supply increases faster than real output then, ceteris paribus, inflation will occur.

If you print more money, the amount of goods doesn’t change. However, if you print money, households will have more cash and more money to spend on goods. If there is more money chasing the same amount of goods, firms will just put up prices.

·         Foreign investors often invest large amounts of capital in government bonds. Key drivers for this – relative difference in domestic and foreign interest rates (assuming the exchange rate is relatively fixed/stable).

o   Exchange-rate volatility impact the demand from these investors and relative attractiveness of overseas bonds vs local bonds.

·         Market expectations, institutional CFs, change in the objective, investment philosophy or outlook affects the demand for bonds.

·         Any market events or economic changes can be analysed as the impact on short-term real rates and inflation. E.g. when equity market outlook is unattractive -> companies raise funds via issuing corporate debt than by creating new share capital. Increased supply of corporate debt issuance would decrease bond prices and increase yields and vice versa.

·         Economic factors adversely affecting corporate profitability would increase expected levels of risks associated with investing in corporate bonds relative to gov’t bonds. This will increase the yield margin of corporate bonds relative to gov’t bonds.

·         If gov’t bonds are low in supply or expensive -> some investors might take additional risks expecting higher returns. This will reduce the yield margin between gov’t and corporate bonds throughout the duration.

4.4.3 Equity market values

·         The overall level of equity market values reflects investor sentiment and expectations regarding future corporate profitability and the levels of these profits.

·         Factors that affect equity markets (relating to investor demand):

o   Real level of economic growth

o   Expected real rates of return

o   Inflation expectations

o   Perceived risk inherent in equity markets

·         Factors affecting demand for equity investments:

o   Opportunity cost of foregone investments (attractiveness in terms of risk and return expectations for other asset classes)

o   Institutional CFs

o   Any tax incentives (e.g. franking credits)

·         Factors affecting supply are usually associated with corporate and management actions such as:

o   Share buy-backs

o   Privatisations

o   Rights issues

·         All of these affect market prices.

·         Equity risk premium – additional return required because of taking on risks relative to the risk-free position. It fluctuates over time to reflect economic cycle an investors’ confidence level and perceived levels of risk in the market.

Inflation and interest

·         High inflation rates would lead to expectations that the dividend growth rate would increase in line to compensate investors’ real return expectations. OR high inflation and interest rates are likely to dampen economic growth, and thus the sustainability of future return expectations would be questioned and lead to the weakening of equity prices. So market does not have concern over high inflation or nominal interest rates.

·         High inflation -> central bank intervene to raise nominal interest rates to preserve real interest rate.

·         Low levels of real interest rates will boost economic activity as well as corporate profitability due to lower funding costs and, hence, the overall level of the equity market.

o   It will also have high PV of future dividends due to lower rate required by investors (modelled via dividend discount model).

o   Dividends will grow in line with real economic growth -> companies’ fundamental values are expected to grow in real terms -> growth in equity market values.

Currency

·         Imports & exports depend on the strength of the domestic currency.

·         Strong domestic currency -> decreases competitive position of exports -> decrease in profits (also due to exchange rates when converted)

o   It also reduces costs associated with imports -> supports corporate profits as companies are unlikely to pass all the cost savings on raw materials to consumers.

o   Lower costs -> reduce inflationary pressure

o   But market share for domestic firms will reduce as it is cheaper to import for local customers.

·         The extent of any currency appreciation or depreciation on overall equity markets will depend on the proportion of profits earned abroad.

4.4.4 Property markets

The three main interrelated factors affecting property markets are:

·         Supply of property through development cycles:

o   Slow to respond to increasing demand -> as it is fixed in location and requires time to gain the necessary approvals and then to develop

o   Causes a lag in economic cycle

o   Results in supply of properties flooding the markets as economy weakens and slows down

o   There are also lags in future supply -> estimated based on existing properties and best estimates of future supply.

o   Also affected by politics relating to controls that could lead to restrictions on property development.

·         Occupational (tenancy) demand

o   Influenced by overall level of the economy

o   During economic growth, property markets are segmented by property sectors and different regions in a country.

o   Economic activity will also affect occupational demand for property. E.g. increase in specific export good -> increase occupational demand for industrial properties suitable to manufacture good. When work culture changes -> demand for domestic and international office property is likely to change.

·         Overall level of investment markets

o   Important factor – investor CFs are net +ve or –ve into property markets

o   E.g. superannuation fund in growth phase may have a steadily increasing requirement to invest in property.

o   The strength of the domestic currency will have a significant influence on the level of demand from overseas investors.

Inflation and interest

·         Higher interest rate -> higher discount rates and lower PVs of future renal income -> lower capital values.

·         But relationship between interest rates and rental yields is less clear in short term due to infrequent rent reviews and valuations.

·         Over the long term, property investments tend to be a good hedge against unanticipated inflation as rent increases with inflation.

·         But infrequent rent reviews could erode the real value of rental income between reviews

·         Reflection: Market prices are driven by supply and demand from sellers and buyers. As demand for an asset increases, the general level of market prices for that asset will increase. Similarly, a reduction in demand will lead to prices falling. The primary driver affecting demand from investors is the expectation of an asset’s riskiness and potential level of returns. What would impact the price elasticity of demand? (Hint: Consider the existence and extent of close substitutes.

o   In general, if there are more people looking to buy homes, home prices rise. If a lot of homes are listed for sale relative to the number of interested buyers, home prices are typically lower. Because homes are normally your biggest purchase, they tend to have a relatively high elasticity of demand.

o   Luxury Or Need

§  As you go up in price range, elasticity increases significantly for housing. Demand exceeds the proportional increase in home prices. This is because luxury items have a higher level of elasticity. If you have plenty of disposable income, you are likely more willing to pay to get what you want.

§  At lower price points, buyers with more middle-class incomes have more budget restrictions and concerns. Thus, a price change from $500,000 to $525,000 likely affects you less than a change from $100,000 to $105,000, even though the percentage price change is the same.

o   Number Of Available Substitutes

§  The number of available substitutes also has an impact on elasticity of demand. When the housing market is saturated with numerous homes for sale and foreclosures, you usually get a better deal because buyers are less willing to pay more than they need to for a good home. Also, if there are plenty of rental properties available, you may decide to rent if you can't get the right house at the right price.

§  This factor also relates to the price range of homes. Since there are usually fewer homes available at higher price points, buyers typically stretch to get what they want. Lower home price ranges usually have more inventory.

o   Loan Interest Rates

§  Mortgage loan interests rates also affect price elasticity in housing. When interest rates are lower, you can afford a larger loan. This enables you to stretch a bit more on home prices, which means an increased elasticity of demand.

§  When mortgage rates increase, the costs of borrowing are higher and you have a more inelastic demand. When the housing market is in a slump, the Federal Reserve may reduce its loan-funding rate for banks to encourage them to offer homebuyers lower rates on borrowing.

4.5 Market participants

Market participants: Supply capital, demand capital and intermediaries.

·         Major players in Capital markets: households (supply capital), corporate organisations (demand capital) and gov’ts (intermediary that intervene if necessary).

·         Ex 4.8: Should banks be listed twice in Figure 4.1?

o   Yes, as Module 3 (Money in the modern economy) would suggest that banks should also be regarded as a supplier of money as well as an intermediary.

·         Economic decisions households make -> impacts economy

o   E.g. spend more and save less -> increase employment, capital investments and thus profit.

·         Corporate investment decisions could potentially impact on the real economy and corporate profits.

·         Gov’t decisions affect economy as there are the largest borrowers and spenders in local economies. Their policies may compel saving (e.g. superannuation) that leads to increase in demand for investible assets and the need for intermediaries

·         Ex 4.9 State why governments are listed twice in Figure 4.1.

o   The relationship between tax revenues and government expenditure leads to a budget surplus (supplier) or deficit (borrower).

·         Intermediaries match up household savings with companies’ demand for capital indirectly. E.g. retirement savings invested in bonds and equity via superfunds.

o   They need to manage assets in the capital markets

·         Credit rating agencies (influence credit spreads above risk-free rates) and custodian banks (used to avoid the time-consuming process of issuing named certificates of ownership) (not listed in 4.1) provide market efficiencies or help with pricing securities.

4.5.1 The asset management industry Background

·         Links capital providers and capital seekers around the world.

·         Provides professional services to a wide range of investors with varying needs and objectives.

·         The industry evolves with technological advancements, demographic and cultural trends, increased globalisation of capital markets and standardisation of regulation

Ownership structure (private vs public)

·         Mostly owned privately by those who founded the firm. They tend to hold key positions in the management structure of the firm. Usually limited partnerships or as limited liability companies.

·         Potential investors often view favourably asset managers who have personal risk through their own capital invested in the firm, as it is seen as an alignment of principal–agent interests.

·         If it is public firm, a typical ownership structure in the industry takes the form of a division within, or a subsidiary of, a large diversified financial services company that offers asset management services in addition to banking and other services such as insurance offerings.

4.5.2 Asset management clients Retail investors

·         Asset managers package investment strategies through highly regulated pooled vehicles.

·         Distributed via financial advisors or their superannuation fund.

·         Many asset managers use online brokerage and custodial firms to distribute investment strategies to investors.

·         They often target high-net-worth individuals as they are more financially literate, require customised investment solutions with tax and estate planning services and ready to pay fees for them.

Institutional investors

·         Marketing is more direct when dealing with large institutional clients.

·         Investment strategies tend to be less regulated and more customisable.

·         Can be grouped as superfunds, insurers, banks, sovereign wealth funds, endowments and foundations.

Superannuation funds/pension plans

·         Pension plans (with DB funds) are employer-sponsored and offer employees a predefined benefit on retirement (either LS or income stream).

o   Employer bear the funding risk to ensure benefits are paid to employees -> if overfunded, then employers use them

o   Trustee invests the plan assets, balancing the objectives of full funding of employee benefits and stable employer funding costs.

·         DC plans are often tax-deferred and funded by both employer and employee.

o   Employee bears all the inflation and investment risk

o   Employee select the investment asset allocation and the trustee then invests the portfolio in accordance with the member requirements

o   Combining all member assets gives trustee a pool to invest in each asset class.

o   Investment objectives are long term but also main sufficient liquidity to meet all lump-sum and pension benefit payments.

Insurance providers

·         LI/GI/ Reinsurers

·         Different target market and business underwritten (e.g. inflation or index-linked; decreasing or varying terms over which the insurance is provided; varying premiums).

·         Premiums received and claims paid to policyholders.

·         When developing an investment strategy -> regulation is important -> different investments attract different capital charges -> affect solvency of the company.

·         Portfolio allocation varies based on duration of liabilities and liquidity considerations across the insurance types. Among these, different assets underlying the capital structure are also likely to have different investment objectives.

·         Larger insurers have their own in-house portfolio management teams to manage their assets and also sometimes offer asset management services.

Banks

·         Financial intermediaries through lending capital to clients and accepting deposits. Also creating money.

·         Like insurance companies, banks are required to hold reserves to ensure solvency and a minimum level of liquidity based on regulations.

·         Reserves with conservative investments in very short duration fixed-income investments, with the aim to earn interest above the ones paid to depositors.

·         Liquidity is critical to ensure to meet depositors’ withdrawal requests

·         Large banks tend to have asset management divisions, offering retail and institutional services and products to clients. The nature and term of these can vary significantly from overnight liquidity facilities, based on bank bill swap rates, to multi-decade mortgage loans. This in itself would require vastly different ALM models to assess the bank’s opportunities and risks.

Sovereign wealth funds

·         Typically state-controlled and/or state-owned investment funds

·         Investments are usually in financial and real assets driven by political objectives

·         Do not specific liabilities or obligations -> fewer restrictions

·         Religion often plays a large role in the countries underpinning these funds and may influence the type of investments permissible. The largest sovereign wealth funds are concentrated in the Middle East and Asia — for example, the Saudi Wealth Fund.

Endowments and foundations

·         Endowments -> Non-profit funds established to provide specific services

·         Foundations -> are typically grant-making entities

·         Both tend to be long term in nature with some of the income generated each year used for services or grants whilst capital remains invested -> they often have large allocations to alternative investments. E.g. Harvard endowment fund

4.5.3 Custodian banks

·         Is a financial institution that holds customers’ securities for safekeeping in order to minimise the risk of their theft or loss.

·         It holds securities and other assets in electronic or physical form

·         Other functions (excl safekeeping):

o   Arrange settlement of any purchases and sales

o   Distribute income received from the securities

o   Administer corporate actions on securities held such as stock dividends, stock splits

o   Keep owners informed of, for e.g. annual general meetings

o   Facilitate foreign-exchange transactions

o   Other additional services for particular clients such as superfunds

o   May include fund accounting, administration, legal, compliance and tax support services

·         Registered as the holders of the securities, but security holders are the legal owners of the securities.

·         Custodian only link owners to the securities.

4.5.4 Credit-rating agencies

·         Is a company that assigns credit ratings i.e. rate debtor’s ability to pay back debt by making timely principal and interest payments.

·         They estimate the prob of default in the payment of interest or principal.

·         Ratings do not differentiate between the consequences of failure to pay or simply just failure to pay -> but loss given default (LGDR) used in credit analysis to make that distinction

·         They assign credit ratings to -> debt instrument (e.g. government bonds, corporate bonds), collateralised securities (e.g. mortgage-backed securities, collateralised debt obligations), and to other organisations who owe debts to third parties (e.g. banks, insurance companies).

·         Higher rating -> lower likelihood of default -> less risk for investors (e.g. highest might be AAA, then AA, A, B)

·         Higher ratings -> lower yields and vice versa -> to compensate those take risks

·         In equilibrium the additional expected return available on a k-rated security should exactly offset the expected additional risk of default implied in the rating k. This additional return -> credit spread.

·         Spread varies market to market and reflects something like a risk-free rate.

·         Reasons not to rely on credit ratings:

o   They are not making an investment in the asset and do not bear direct responsibility for the investment outcome.

o   Agency theory suggests that incentive alignment is fundamental to ensuring an agent acts in the principal’s best interests — however, in some markets the agencies are not paid by the principal investor, rather by the security or issuer being assessed

o   Variable track record over time

o   While ratings are forward looking and reviews are conducted regularly and after significant events or announcements, changes in ratings tend to lag changes in fortune

·         Ex 4.10: Provide an example for each of the first three bullet points in the list above.

1.       Agency not investing and no responsibility A pension fund, for example, does not appoint a credit agency to manage an investment mandate as it appoints the investment manager and the manager must make their own assessment of the adequacy of the rating.

2.       Non-alignment of incentive. Issuers pay the ratings agencies assigning the rating, resulting in a misaligned incentive when viewed from the end investor’s perspective. Notwithstanding the expertise, experience, and diligence of individual firms, it is possible to argue that payment for rating presents an agency with a fundamental conflict of interest.

3.       Variable track record. Hundreds of billions of securities that were given the agencies' highest ratings were downgraded to junk during the financial crisis of 2007–08 (the GFC).

·         Moody’s and S&P cover 80% of the global market. Fitch controls about further 15%.

·         Each agencies use different methods. Short-term ratings may differ from long-term ratings

·         The intention across the agencies is similar as issues are rated investment grade if they rank above a certain minimum rating (around BB+) or below investment grade (BIG).

·         BIG bonds are sometimes called high yield or junk bonds. Issues that do not warrant even a minimum rating are called unrated.

4.6 Raising capital and trading securities

·         New capital to finance new investment projects -> borrow money (issue a debt security) or sell part of the ownership of the firm (issue shares).

·         Securities are issued in primary market and then holders trade them in the secondary market.

4.6.1 Sources of Capital

·         Maturity of organisation -> starts at sole trader promoting prototype to large-multinational publicly listed company.

·         Some grow large but remain private e.g. Bacardi Lts and Cargill Inc.

·         Start (financed as venture capital) -> Private -> Public

·         Venture capitalists require higher return in exchange for the risk and also provide managerial and technical expertise.

·         Reflection: There is a very successful business-related reality TV show called ‘Shark Tank’, where investment-seeking entrepreneurs make business presentations to a panel of five investors (the ‘sharks’), who then choose whether to invest in the company as a business partner. Have a look for an episode on YouTube, as the negotiations often involve concepts that appear throughout this subject.

o   Sharks find weaknesses and faults in an entrepreneur's valuation of their company, product, or business model

o   The entrepreneur can make a handshake deal (gentleman's agreement) on the show if a panel member is interested. However, if all of the panel members opt out, the entrepreneur leaves empty-handed.

o   About 20% of the handshake deals made on the show are never executed, due to the investors' due diligence process following the handshake deal, which includes product testing and examining the contestants' business and personal financials. Fellow Shark Robert Herjavec believes that about 90% of those withdrawals come from the entrepreneur, in some cases due to only appearing on the program for publicity.

·         If start-up is successful -> raise further tranches of venture capital. The successful firm may now be owned by a few shareholders with a longer-term view. If there are no secondary market, they raise capital via secured or unsecured debt.

4.6.2 Initial public offering

·         Private firm go public to raise capital from wider pool of investors via stock exchanges.

·         Initial public offering (IPO) – the first offering of shares to the public

·         First stage -> select an investment bank -> they purchase all the stock and resell to the public (guaranteed at a specified minimum price).

·         Bank will also have knowledge, expertise and industry contracts to execute the process.

·         Bank retains all shares that are not sold -> underwriter

·         IPO timescale is 9-12 months (mainly due to regulatory approval). Longer if marker is unfavourable.

·         Underwriter knows the main potential investors -> (e.g. superannuation funds, investment houses) and a preliminary prospectus is issued to those potential investors.

·         Roadshows are organised where management meets potential investors. The opportunity to see management will help potential investors gain information on the company. The outcome from the roadshows will determine if there is interest in the IPO.

·         Book building -> process of polling potential investors on their interests. It includes seek acceptable price and likely trading volume sought by potential investors. Then shares are allocated partial based on that.

·         Price is set to be low enough price to entice potential investors.

·         IPO shares typically, but not always, rise in price on the first day of trading, which suggests there is an implicit cost in the IPO process.

·         The underwriter will create an underwriting syndicate to share the risk that not all shares will be placed. This syndicate will be bound to purchase any shares that are not sold through the book-building process. The underwriter will charge an additional fee for taking on the risk that not all shares will be sold -> underwriting fee.

·         Price of unsold shares < price offered to investors

·         Ex 4.11 The prospectus issues to potential investors in an IPO must be a true and fair representation of relevant financial matters. The directors are liable if the prospectus is untrue and the lead underwriter will undertake a due-diligence process on operations, legal, accounting, and tax positions.

List broad categories of information that you think would be in the prospectus.

o   information about the industry

o   current and historical information on the business

o   brief CVs of the board members and relevant senior management

o   detailed explanation of the tax position

o   financial forecasts

o   the legal aspects of the business.

4.6.3 Trading in secondary markets

·         Different exchanges have different rules and customs. E.g. US has 3 STX (NYSE, AMEX, NASDAQ) while Australia has ASX.

·         These US exchanges have different listing requirements. For example, NYSE requires much greater minimum net assets, public shares, and shareholders than NASDAQ.

·         Equity markets also operate differently across countries.

o   NYSE -> pure auction market -> matched by brokers

o   London STX -> dealer market -> trades with individual dealer who have their own stock (market makers)

o   Tokyo STX -> attractive stocks trade in auction market and less active or foreign firms are traded in dealer market

·         Financial analysis is done by an analyst who will ensure the reports are converted to proper standards prior to analysis. (IFRS17 vs GAAP)

·         Global markets have a much wider range of securities than any one market with different features. E.g. mortgage-backed securities in Australia are almost all floating-rate notes. While in US, they are fixed-rate securities issued by agencies.

·         Counterparty risk – likelihood/ probability that one of those involved in transaction might default on its contractual obligation.

o   It can exist in credit investment and trading transactions.

o   Trading via exchanges reduces this risk

o   Derivative contracts are often OTC and hence the purchaser should consider the risk that the seller will not deliver the agreed contract, especially if there is a long period before settlement is due.

4.6.4 Short selling

·         Where an individual sells an asset that they do not own with the intention of purchasing the asset at a lower price at a future date. E.g. borrow some stock, sell it in open markets, repurchase it in the future and give it back to the original dealer.

·         Naked selling – when a short seller sell on the open market without having borrowed the stock.

·         It is allowed in STX if the seller has borrowed the stock from an authorised dealer -> covered short selling

o   Dealer may be custodian of a wide variety of securities that belong to other investors.

o   Short seller borrows stock in return for a fee for either a fixed or an indeterminate period and the actual owner of the stock is unlikely to be aware of this.

o   If the actual owner decides to sell the stock -> dealer will borrow stock from another investor. If no stock left -> stock re-called from short seller and they will have purchase stock from the open market.

o   When there is a lot of uncertainty in stock markets there is a fear that short sellers will cause downward pressure on share prices and governments may respond by temporarily banning short selling.

§  But is the short seller causing the fall in price or anticipating the fall in price? Banning short selling appears to be appropriate if the process is causing falls, but if the process is simply anticipating falls, then that may be of use to regulators.

4.7 Index construction and uses

·         Returns on stock markets, captured by changes in an index

4.7.1 Index construction

·         Indices are usually produced using a weighted arithmetic mean of its underlying constituents.

·        

·         3 ways to calculate weights:

o   Market capitalisation method

§  The factor for each stock is equal to its market capitalisation

§  Market capitalisation = number of issued shares x current market price

§  But indices often restrict market capitalisation to those shares that are freely tradeable.

§  The market value of a portfolio that is invested in proportion to the market capitalisation of the constituents will change in line with a market capitalisation index.

o   Price weighted method

§  Calculated as the sum of individual prices divided by number of constituents (the divisor)

§  The index corresponds to a portfolio that holds one unit of each of the components throughout the measurement period.

§  Some events will cause the divisor to change e.g. company splitting shares -> price falls immediately or constituent is replaced with another.  

§  It is an older method than the market-capitalisation method but still is used.

o   Equal weighting method

§  Measures market performance by an equally weighted average return of the constituents of the index

§  A portfolio attempting to mimic an equal-weighting index would need to be rebalanced at the end of each measurement period as changes in the capital values of the different constituents will differ.

o   You need to watch this to understand: https://www.youtube.com/watch?v=GCvta7ENqj4

 ·         Ex 4.12

1.       For t=0, (1x10+2x20+3x30+4x40+5x50)/1=550 and

t=1, (2x10)+(1x20)+(4x30)+(5x40)+(20x50)/550=1360/550 = 2.48

2.48-1=148%

2. For t=0, (1+2+3+4+5)/0.6 = 25

For t=1, (2+1+4+5+20)/0.6 = 53.33

53.33/25-1 = 113%

2.       The initial purchases $ value is 1+1+1+1+1 = 5

The number of stocks initially purchased is the purchase value divided by price at time 0 for each.

1/1, 1/2, 1/3, 1/4 and 1/5

Then later time 1 index value is the sum of the (number of stocks held times price at time 1), divided by divisor of 5 unchanged

(2*1/1+1*1/2+4*1/3+5*1/4+20*1/5)/5 = 9.08/5 = 1.816

Return +81.6%

Assumptions:

1.       The opening value of the market cap index is arbitrary and has been set to 1.

2.       There is no change to the divisor for the price index over the period.

3.       All calculations are measuring the change in capital values and other income (e.g. dividends) are ignored.

Comments:

The change in index values are very different as they are measuring different things.

1.       The market value of a portfolio that is invested in proportion to the market capitalisation of the constituents will change in line with a market capitalisation index.

2.       The price index corresponds to a portfolio that holds one unit of each of the components throughout the measurement period.

3.       A portfolio that invests equal dollar amounts in the constituents for a period would provide a return in line with this type of index

 ·         Ex 4.13: Suppose that company E in the previous question underwent a four-for-one stock split at the end of the period. Calculate the revised divisor for the price-weighted index.

o   There will be 200 shares in issue following the stock split and we expect the market price to fall from $20 to $5. This leaves the market capitalisation of stock E unchanged at $1,000.

o   The index value immediately before the split is 53.33 and there must be no change post-split.

o   The new divisor = (2+1+ 4+5+ 5)/53.33 = 0.31877.

4.7.2 Uses of indices

·         Market indices may be used as:

o   A record of how prices change over time

o   A tool when analysing actual portfolio returns

o   An instrument for passive portfolio management, or as a proxy for actual asset returns

·         Ex 4.14 Describe how changes in a market over time may be used by an investor.

o   The question states ‘changes over time’, which provides a hint that splitting up time periods may generate answers:

§  To answer questions on recent market movements

§  To inquire about the relative attractiveness of an asset class by considering the current market level against the levels in some past periods

§  Historical studies to investigate (e.g. the equity risk premium) or compare the effects of reinvesting dividends.

·         Index should have the following properties be useful or tradeable:

o   Representative – of what it is attempting to measure. E.g. measure the strength of companies operating in UK -> open economy and top 100 trade across the world -> FTSE100 does not represent UK domestic market and is affected by exchange rate.

FTSE250 represent next 250 companies by market capitalisation -> focused on the UK market.

o   Investible – when assets within the index is freely available. Market-capitalisation indices only allow for purchasable stock. If cannot invest in assets -> reduces interest in the index.

o   Transparent – indices are constructed using rules and these need to be transparent and publicly available. Investors need to be confident rules will not be arbitrarily changed -> it should be flexible enough to cope with unforeseeable events such as rights issues.

·         Ex 4.15: Identify other unforeseeable events that need addressing when setting the rules for indices.

o   share splits

o   scrip issues — additional shares in proportion to shares held

o   change of constituents from mergers, acquisitions, or successful new companies.

4.7.3 Price index versus accumulation index

·         Indices from previous section only give short-term speculation.

·         Actuaries should know total return from a portfolio to allow for reinvestment of any dividend income or coupon from debt securities.

·         Accumulation index or total return index ->index that allows for the reinvestment of income

·         Accumulation indices -> hard to calculate than price indices

o   Is corresponding price index adjusted for the notional reinvestment of dividends.

o   The reinvestment of dividends for a stock is assumed to occur on the date the stock goes ex-dividend. On the ex-dividend date, the price of a stock usually falls as the purchaser on that date is not entitled to the declared dividend.

·         Issues with calculating an accumulation index:

o   Dividends cannot be invested until the cash is received, which may be several weeks after the ex-dividend date

o   Taxation of the dividends may be ignored or for the average institutional investor.

·         Whatever the calc method, rules have to be transparent and flexible for the index to be useful to investors.

·         Ex 4.16: How will the two issues relating to calculating an accumulation index affect the index?

o   Assuming that indices go up over time, the accumulation index will overstate actual returns as they assume the dividends are invested before the actual reinvestment date.

o   The value of the dividends depends on the tax status of the investor. For example, a superannuation fund with low or zero tax rates will see a higher return than suggested by the index.

4.8 Key learning points

•        Investible assets may be categorised into six broad classes — physical (including property), debt, equity, hybrids, derivatives of underlying assets, and securitised assets.

•        Investments in different asset classes should have different risk and return characteristics and perform differently in similar market conditions.

•        Economic factors can be expressed in terms of short-term real rates as well as inflation. As such, any market events or economic changes can be analysed as the impact on these two factors and their resulting impact on the demand and supply of bonds.

•        The overall level of equity market values reflects investor sentiment and expectations regarding future corporate profitability and the levels of these profits, as well as supply and demand factors.

•        The three main interrelated factors affecting property markets are supply (development cycle), occupational (tenancy) demand, and the overall level of investment markets.

•        The three major players in capital markets are households, corporate organisations, and governments.

•        The asset management industry provides an important link between capital providers and capital seekers around the world.

•        Key market participants are institutional investors, asset management companies, custodians, and credit-rating agencies.

•        To finance new projects, an organisation can either issue a debt security or issue shares. Investors purchase new securities in what is labelled the primary market. Once the securities are issued, the holders may trade them in the secondary market (often a regulated exchange).

•        Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Trading through an exchange reduces counterparty risk.

•        For a market index to be useful, it should be representative, investible, and transparent.

UK CA1

1. List the possible uses of investment market indices

a)      A measure of short-term market movements.

b)      Providing a history of market movements and levels

c)       As a tool for estimating future movements in the market, based on past trends

d)      As a benchmark against which to assess the investment performance of portfolios.

e)      Valuing a notional portfolio.

f)       Analysing sub-sectors of the market.

g)      As a basis for index funds which track the particular market.

h)      To provide the basis for the creation of derivative instruments relating to the market or a sub-section of the market.

2. State with reasons the uses for which the following US equity indices would be appropriate:

·         the Dow Jones Index

·         the Standard & Poor's Composite Index

o   The DJI is made up of 30 shares. Although commonly quoted, the small number of companies does not make it a good indicator of overall market performance.

o   Suitable for (a) and (e) and possibly use for (g) and (h).

o   It has a long history, so despite the above disadvantage, it might also be used for (b) if a long time period is involved.

o   The S&P Composite Index is made up of the 500 leading companies in the USA and it represents a broad cross-section of all sectors of the market. It is therefore suitable to use for performance measurement of an investor’s USA equity portfolio. (d)

o   It is suitable for all uses in part(i). [Note, I would debate useful for (f)]

UK CA1

A developed country has moved into recession in the last year. In order to boost growth the central bank has lowered short-term interest rates substantially over the last few months.

(i) Discuss how economic growth, the exchange rate, and inflation in this country might develop over the next two years.

Economic growth

•        Lowering short rates encourages investment spending by firms, and increases the level of consumer spending.

•        There can be a considerable lag between lowering interest rates and a pick-up in growth.

•        Capital investment spending by firms increases employment levels and therefore incomes, but it takes time for firms to plan and build new production facilities before they start producing goods.

•        To increase consumer spending you need to do one or more of:

o   Increase disposable income by reducing the cost of servicing existing debt - the effect will be more immediate if borrowing is generally at floating rather than fixed rates.

o   Discourage savings and / or encourage spending of savings - lower interest rates provide less reward for saving, however, consumers need spending.

o   Encourage personal borrowing - lower interest rates make borrowing cheaper but consumers need confidence (e.g. job security or prospects) before borrowing to spend.

•        The return of consumer confidence will take time to emerge.

Exchange rate

•        Initially the exchange rate should fall.

•        Lower interest rates reduce the demand for the domestic currency.

•        Lower exchange rates should increase the competitiveness of all exports. This is despite increasing the cost of imported materials used in production.

•        Lower exchange rates should increase the relative competitiveness and demand for domestically produced goods and services stimulating domestic growth in the next two years.

Inflation

•        Lower exchange rates will increase the cost of imported goods and services leading to supply side inflation. The impact on the inflation rate will depend on whether these higher costs can be passed on to consumers. Weak demand and the presence of domestic alternatives are a limiting influence.

•        The use of forward currency contracts will create a longer lag.

•        Lower real interest rates mean an increased quantity of money is demanded which is met by an increase in the money supply. This can lead to inflation (demand side). Demand side inflation typically has a longer lag than economic growth.

Tutorial 2

Give four reasons why unlisted property valuations are quite subjective.

•        Every property has unique features (heterogeneous market) making it difficult to apply the price of one property to another.

•        Limited number of buyers at any one time and limited number of available properties at any one time (illiquid market), ‘fire sale’ pricing may not reflect underlying value.

•        There is infrequent trading activity so last trade may no longer be a guide.

•        There is no central market with quoted prices.

•        Information about a property is limited and/or confidential.

•        Many pricing factors are themselves subjective or difficult to estimate, e.g. future demand for location by tenants, quality of property, quality of tenants, standard (and cost) of refurbishment required, etc.

Give four reasons why the trustee of a self-managed superannuation fund might consider an overseas investment for the fund’s portfolio.

•        Risk and return characteristics of overseas asset class (market) compare favourably to local asset class (market) ie better meet investor’s objectives

•        To diversify, particularly as the lower the level of correlation of market returns between countries invested, the more diversification benefits

•        Access to industries not operating in home country (leading to diversification benefits)

•        Variation in market expectations and pricing between countries, some countries may be undervalued and hence a buying opportunity (arbitrage)

•        To exploit expected changes in exchange rates

Market participants can be grouped into suppliers of capital, users of capital and intermediaries. Identify the group(s) where commercial banks fit and explain why.

•        In its simplest form, corporations use (demand) capital and households supply it.

•        Banks have a clear role as intermediaries by offering bank accounts to all parties that facilitate the flow of capital from one to the other, and providing other services related to holding/investing capital

•        (Investment) banks also have an intermediary role assisting companies to raise capital, including advising the company, finding buyers, guaranteeing to buy shares on IPOs.

•        Banks also supply money, by issuing loans to householders and companies

•        Banks also require capital to operate (as they are companies) so also are users of capital

[sfactuary]

Asset Liability Management

3.    MONEY IN THE MODERN ECONOMY

3.2 Government Policy

3.2.1 Supply-side and Demand-side management

•        Supply-side management

o   Manipulate productive capacity of an economy by maximising economic output

o   Gov’t policy attempts to affect the supply of goods and services

o   Ex 3.1 Examples of ways gov’t boost supply of goods

§  Privatisation – selling state owned assets to private sector

§  Deregulation

§  Reducing income tax rates

§  Deregulate labour market

§  Reducing the power of trades unions

§  Reducing unemployment benefits

§  Deregulate financial markets

§  Increase free-trade

§  Improve education and training

§  Textbook answer: Cutting regulations may improve the speed of production times by removing restrictions (e.g. no noise after 10 pm) or loosen reporting requirements.

Cutting income taxes would incentivise workers to work longer and theoretically provide better returns for those investing their capital.

 o   Related concept: supply shock to the economy -> event that influences production capacity or costs.

o   Ex 3.2: 3 Outline supply shocks to an economy

§  Steep rise in oil and gas prices (or other commodities)

§  Political turmoil/strikes

§  Natural disasters causing sharp fall in production

§  Unexpected technology breakthrough

§  Textbook sol’n:

·         changes in rates of pay that are acceptable to a workforce (e.g. consider changes in pay rates post the UK’s withdrawal from the EU and subsequent change in the pool of workers);

·         changes in educational levels (e.g. aiming for 50% of school-leavers to attend universities);

·         natural disasters — COVID-19 epidemic and the impact on businesses because of requirements to enforce social distancing, but with some offsetting consequences (e.g. huge reduction in the price of oil).

 •        Demand-side management

o   Attempts to stimulate the demand for goods and services

o   Aggregate demand in an economy has 4 components:

§  Consumption of goods and services

§  Investment in tangible assets that are used to produce goods

§  Government spending on public goods and services

§  Net exports

o   Demand shocks: events that affect the demand for goods and services

o   Ex 3.3: Demand shocks for components of AD:

§  Economic downturn in a major trading partner

§  Unexpected tax increases or cuts to welfare benefits

§  Financial crisis causing bank lending/credit to fall

§  Bigger than expected rise in unemployment rates

§  Given sol’n:

·         Consumption of G&S – cut taxes

·         Investment – reduce interest rates

·         Gov’t spending – e.g. rail, hospitals

·         Net exports – reduce interest rate, lowering demand for currency

o   Ex 3.4: Discuss the relative speeds of the effects of supply-side management and demand-side management on an economy. (Hint: Start with the definitions of the two concepts and then make some broad statements about the relative speeds.)

Supply-side management attempts to manipulate the productive capacity of an economy. Thus, government policy may be created that attempts to affect the supply of goods and services.

An example is a policy to change the educational level of the workforce (e.g. raise the percentage of the population who attend universities). The policy may take a few years to come fully into effect and there is likely to be further delays until the increased percentage of university-educated people enter the workforce.

Demand-side management attempts to stimulate the demand for goods and services. Examples of actions that may be taken are cutting interest rates or increasing the money supply. The effects may be seen almost immediately.

A conclusion is that demand-side management may affect economic output much quicker than supply-side management. Note that this does not mean demand-side policies are preferable or more effective in the long run.

  3.2.2 Monetary and fiscal policy

2 main demand-side macroeconomic tools available to gov’t are:

•        Monetary policy

o   Directed towards activities that aim to influence the quantity of money and credit in an economy, usually via interest rates

o   Change in interest rates -> change in investment demand. As quantity of money changes -> % of assets in investors’ portfolios will change and they may rebalance their portfolios. This will affect prices of other asset classes.

o   It has short-term effect, the LT effect is less clear. E.g. lowering investment rates stimulates investment and consumption in demand in the ST but, in LT, this leads to higher prices. i.e. stimulus may have LT inflationary effect.

o   It should balance the trade-off between economic stimulus and inflation

o   Ex 3.5 Why is it difficult not to be more definitive about the long-term effects of an expansion?

§  Economics is the study of production, consumption, and wealth. These involve the actions of individuals and governments in a very complicated environment.

§  There is a time lag between the implementation of a monetary policy decision and the long run. Many other decisions will be made in that timeframe that invalidate a direct observance of the policy under investigation.

•        Fiscal policy

o   Relates to gov’t activities focused on taxation and spending

o   Direct way gov’t can change the growth of an economy. e.g. increase in gov’t spending -> increases demand for G&S; tax rises as consumers have less money reduces demand.

o   It aims to influence:

§  Allocation of resources between different sectors and economic agents

§  Overall level of AD and the level of economic activity

§  Redistribution of income and wealth between different segments of the pop’n

 •        Fiscal requires gaining agreements while monetary can be outsourced to a central bank and completed quickly.

•        Both MP & FP affect economic activity and can be used to regulate economic growth over time. They aim to create a sustainable economic environment where growth is +ve and stable, inflation is under control (low but +ve).

•        Challenges for these include: natural cycle i.e. business cycle and how driver in the global economy affect the domestic economy.

•        Ex 3.6: The natural cycle of expansion and contraction of an economy is known as the business cycle. This cycle is not regular, and it is important to note its effect on the overall investment market.

Industries that are sensitive to the business cycle are called cyclical industries. Industries that have little sensitivity are known as defensive industries.

Provide some examples of cyclical and defensive industries.

o   Cyclical industries — white goods (e.g. washing machines), cars, capital goods (i.e. goods used to make other goods) would be sensitive to recessions.

o   Defensive industries — food manufacturing, food producers, drugs, water companies.

3.2.3 Central banks and monetary policy tools

•        Functions:

§  Monopoly supplier of currency i.e. banknotes

§  Gov’t’s banker

§  Bankers’ bank – the lender of last resort

§  Regulation and/or supervision of the commercial banking system (oversea payments and financial system)

§  Responsible for the implementation of monetary policy, primarily through the setting of interest rates

•        Central banks are independent of gov’t which allows the execution of monetary policy without influence from ST political pressures

•        Ex 3.7: Responsibility of Central bank: (b) is wrong

•        Tools central banks have to influence and manage monetary policy:

§  Open-market operations (OMO):

·         An activity by a central bank to increase or decrease the liquidity of the domestic currency to, or from, a bank or group of banks. i.e. it influences money supply in an economy

·         Used to influence by purchase and sale of gov’t bonds to/from commercial banks/ designated market makers to change the amount of money in circulation

·         Preferred method now is via repo agreement – provides money to a bank for defined period for an eligible asset from the bank

·         E.g. CB buy gov’t bonds from commercial bank increases money in circulation (ex-nihilo where money is created out of nothing). Banks use it increase lending to households and corporations.

·         E.g. CB sell gov’t bonds to commercial bank reduces the quantity of money in circulation, reducing ability to make loans.

§  The interest rate

·         The rate at which central bank is willing to lend money to commercial banks

·         It is a target rate and not a fixed number

·         CB will lend or borrow money in unlimited quantities until the market rate is close to the target rate

·         If CB increase its official interest rate, banks then follow and increase their base rates at the same time.

·         Ex 3.8: A commercial bank’s base rate is the reference rate on which it bases lending rates to all other customers. For example, large corporate clients might pay the base rate plus 50 basis points on their borrowing from a bank, while the same bank might lend money to a small corporate client at the base rate plus 200 basis points.

Why would commercial banks immediately increase their base or reference rates just because the central bank’s refinancing rate has increased?

o   Commercial banks would not want to have lent at a rate of interest that would be lower than they might be charged by the central bank.

·         Higher the official interest rate, the higher the potential penalty that banks will have to pay to the central bank if they run out of liquidity, which, in turn, decreases their willingness to increase lending and the more likely it is that broad money growth will shrink.

§  Quantitative easing

·         Tool used in low interest rate environments where conventional monetary policy tools have become ineffective.

·         Involves CB purchasing financial assets from non-banking sector

§  Capital requirements

·         CBs are required to hold a % of their assets as capital by the regulators to prevent banks from excessive lending

§  Reserve requirements

·         CB regulation that sets minimum amount of reserves that must be held by a commercial bank.

·         It should not be less than a specified % of the amount of deposit liabilities the commercial bank owes to its customers.

·         Commercial bank’s reserves include cash in vault and balance account with central bank

·         CB can restrict money creation by setting (and raising) reserve requirement for banks. But usually it’s done by regulator to maintain solvency (not economic activity more broadly). E.g. relaxed capital requirements in March 2020 so banks can continue lending during depressed economic conditions.

·         If CB increases reserve requirements, banks might have to cease lending activities to build up necessary reserves, as deposits would be unlikely to build up quickly.

·         Ex 3.9: Central banks can influence the supply of money in three ways, namely:

o   through open-market operations

o   setting official interest rates and playing a lender of last resort role in the repo market

o   setting (and potentially raising) reserve requirements.

3.3 An introduction to money

•        Money fulfils three primary functions, namely:

o   it acts as a medium of exchange

o   it provides a way of storing wealth

o   it provides society with a convenient measure of value and unit of account.

•        For money to act as a medium of exchange, it must possess certain characteristics, namely:

o   have a known value

o   be readily acceptable

o   have a high value relative to its weight

o   be easily divisible

o   be difficult to counterfeit.

•        Some drawbacks of holding savings in physical gold today are:

o   storage costs are not negligible

o   gold is not easy to move around (needs to be in a secure vault)

o   gold generally falls in value when interest rates are up.

Gold is seen as less attractive (i.e. price is expected to go down) in economic environments where interest rates are increasing (because an investor earns no yield on gold, whereas holding, say, bonds is more attractive when interest rates are higher due to interest payments being higher on new bond issues).

•        The three different forms of money are:

o   Currency is made up mostly of banknotes, most of which are an IOU from the central bank to the rest of the economy. Currency is mostly held by consumers, although commercial banks also hold small amounts in order to meet deposit withdrawals. As stated in their inscription, banknotes are a ‘promise to pay’ the holder of the note, on demand, a specified sum (for example £5). This makes banknotes a liability for the central bank and an asset for their holders.

o   Currency only accounts for a very small amount of the money held by people and firms in the economy. The rest consists of bank deposits. For security reasons, consumers generally do not want to store all of their assets as physical banknotes. Moreover, currency does not pay interest, making it less attractive to hold than other assets that do, such as bank deposits. For these reasons, most consumers prefer to hold an alternative medium of exchange: bank deposits. Bank deposits can come in many different forms — for example, current accounts or savings accounts held by consumers or some types of bank bonds purchased by investors. In the modern economy these tend to be recorded electronically.

o   Commercial banks need to hold some currency to meet frequent deposit withdrawals and other outflows. But using physical banknotes to carry out the large volume of transactions they do with each other would be extremely cumbersome. So, banks are allowed to hold a different type of IOU from the central bank known as central bank reserves. These reserves are just an electronic record of the amount owed by the central bank to each individual bank.

 Reserves are a useful medium of exchange for banks, just as deposits are for households and companies. Indeed, reserves accounts at the central bank can be thought of as playing a similar role for commercial banks as current accounts play for households or firms. If one bank wants to make a payment to another — as they do every day, on a large scale, when customers make transactions — they will tell the central bank, which will then adjust its reserve balances accordingly. The central bank also guarantees that any amount of reserves can be swapped for currency should the commercial banks need it. For example, if lots of households wanted to convert their deposits into banknotes, commercial banks could swap their reserves for currency to repay those households. As discussed earlier, as the issuer of currency, the central bank can make sure there is always enough of it to meet such demand.

3.4 Money in creation in a modern economy

3.4.1 Money in creation by commercial banks

•        Exercise 3.14:

Your friend argues that they have just caused the central bank to print another $25,000 in banknotes as they have received a loan approval of $250,000. She argues that the central bank requires the lender to hold a reserve equal to 10% of all loans. Explain what actually happened when she successfully applied for the loan.

 •        Exercise 3.15

A common misconception is that bank deposits are assets that can be lent out and thus create more money. Explain why this is not correct.

Bank deposits are simply a record of how much the bank itself owes its customers. So, they are a liability for the bank, not an asset that could be lent out.

Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.

 •        Exercise 3.16

Loan creation and deletion are the main ways that bank deposits are created and destroyed. Give examples of other ways of creating or deleting bank deposits.

Deposit creation or destruction will also occur any time the banking sector (including the central bank) buys or sells existing assets from, or to, consumers, or, more often, from companies or the government.

Banks buying and selling government bonds is one particularly important way in which the purchase or sale of existing assets by banks creates and destroys money. Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw currency in large amounts. When banks purchase government bonds from the nonbank private sector they credit the sellers with bank deposits. Central bank asset purchases, known as quantitative easing or QE, have similar implications for money creation.

 Money can also be destroyed through the issuance of long-term debt and equity instruments by banks. In addition to deposits, banks hold other liabilities on their balance sheets. Banks manage their liabilities to ensure that they have at least some capital and longer-term debt liabilities to mitigate certain risks and meet regulatory requirements. Because these ‘non-deposit’ liabilities represent longer-term investments in the banking system by households and companies, they cannot be exchanged for currency as easily as bank deposits, and therefore increase the resilience of the bank. When banks issue these longer-term debt and equity instruments to non-bank financial companies, those companies pay for them with bank deposits. That reduces the amount of deposit, or money, liabilities on the banking sector’s balance sheet and increases their non-deposit liabilities.

 Buying and selling of existing assets and issuing longer-term liabilities may lead to a gap between lending and deposits in a closed economy. Additionally, in an open economy deposits can pass from domestic residents to overseas residents, or sterling deposits could be converted into foreign currency deposits. These transactions do not destroy money per se, but overseas residents’ deposits and foreign currency deposits are not always counted as part of a country’s money supply.

 •        Exercise 3.17

Summarise the constraints on money creation by banks.

 Commercial banks may create money through their lending practices, but these are not without limits. More specifically, banks face the following constraints, which limit their ability to create money:

o   internal and external factors limit a bank’s ability to lend

o   the behaviour of households and businesses influences a bank’s lending capacity

o   monetary policy is the ultimate constraint on money creation.

Internal factors such as a bank’s own risk appetite and return requirements will constrain a bank from making additional loans, especially if these are less profitable.

 External factors such as regulation and capital requirements limit a bank’s ability to take on excessive risks that could present a threat to the stability of the financial system. Other external factors such as the competitive environment affect the profitability of a bank and, hence, its ability to lend money.

 Households and businesses influence and potentially constrain the creation of money. For example, if households and businesses use any new loans to repay existing debt, it immediately destroys the newly created money. This limits the bank’s ability to continue lending.

 Monetary policy affects how much households and businesses want to borrow through directly influencing the loan rates charged by banks (i.e. through influencing the cost of money via the level of the cash rate), but also indirectly through the overall effect of monetary policy on economic activity more broadly. Central banks are often responsible for setting short-term interest rates to influence the level of inflation through their monetary policy. In contrast, fiscal policy refers to government decisions that are directed towards spending and taxation, which is often used to redistribute income and wealth.

 •        Exercise 3.18

List three economic conditions that could potentially increase the attractiveness of money market investments to investors who have long-time horizons and seek to maximise returns.

 Some examples of when money market investments would become more attractive to long-term investors are as follows:

o   money market investments provide more capital stability during times of economic uncertainty due to the short-term nature of the investments

o   depreciation of domestic currency could lead to money market investments in other countries becoming attractive

o   expectation of rising interest rates may lead to investors reducing their long-term bond exposure while increasing their positions in short- term debt instruments. Money market investments are less sensitive to rate increases than longer-maturity bonds that lock in the rising rates for longer time periods (reducing market value)

o   changes in the economic cycle, specifically at the start of a recession where equity markets are expected to have slower growth (if any) and fiscal spending dampens bond returns.

3.4.2 Quantitative easing

•        Exercise 3.19

Explain what would happen if the central bank rate was negative.

 If the central bank were to lower interest rates significantly below zero, banks could swap their bank reserves for currency, which would pay a higher interest rate (of zero, or slightly less after taking into account the costs of storing currency). Or put another way, the demand for central bank reserves would disappear, so the central bank could no longer influence the economy by changing the price of those reserves.

 •        Exercise 3.20

Explain QE and its effects on the quantity of money in an economy.

 Quantitative easing (QE) is a program of asset purchases by the central bank that has the aim of providing further monetary stimulus to the economy.

 QE involves a shift in the focus of monetary policy to the quantity of money: the central bank purchases a quantity of assets, financed by the creation of broad money and a corresponding increase in the amount of central bank reserves. The sellers of the assets will be left holding the newly created deposits in place of government bonds. They will probably hold more money than they would like, relative to other assets that they wish to hold. They will, therefore, want to rebalance their portfolios — for example, by using the new deposits to buy higher-yielding assets such as bonds and shares issued by companies. This will raise the value of those assets and lower the cost to companies of raising funds in these markets. That, in turn, should lead to higher spending in the economy.

 •        Exercise 3.21

Do you agree with the comments that QE is not free money for banks?

 While the central bank’s asset purchases involve — and affect — commercial banks’ balance sheets, the primary role of those banks is as an intermediary to facilitate the transaction between the central bank and the pension fund. While banks do earn interest on the newly created reserves, QE also creates an accompanying liability for the bank in the form of the pension fund’s deposit, which the bank will itself typically have to pay interest on. In other words, QE leaves banks with both a new IOU from the central bank but also a new, equally sized IOU to consumers (in this case, the pension fund), and the interest rates on both of these depend on Bank Rate.

 Thus, on balance, QE is not free money to banks.

3.5 Key learning points

•        The performance of an economy can be influenced using a combination of monetary policy and fiscal policy.

•        Monetary policy is aimed at central bank activities that influence the quantity of money and credit in an economy.

•        Fiscal policy is aimed at government activities and spending and the funding of these activities through taxation.

•        Central banks can take on multiple roles, but, most importantly, they act as lender of last resort.

•        Central banks are limited in their ability to manipulate the supply of money as they cannot control the amount of money that households and corporations put in banks on deposit, nor can they easily control the willingness of banks to create money by expanding credit.

•        Instead, central banks can merely influence the supply of money through initiatives such as setting the level of interest rates and hence the cost of providing credit.

•        Inflation targeting is the most common form of monetary policy.

•        Exchange-rate targeting is also used, particularly in developing economies, but to a lesser extent compared to inflation targeting.

•        Money plays three important roles, namely:

o   acting as a medium for exchange

o   providing a mechanism for storing wealth

o   providing society with a convenient unit of account.

•        Commercial banks create money by making loans to individuals and corporations.

•        Quantitative easing attempts to increase aggregate demand by significantly increasing the money supply in a low interest rate environment.

Quantitative easing questions - example

Describe how Quantitative Easing works.

•        Quantitative Easing (QE) is a monetary policy used by some central banks to increase the supply of money

•        It usually involves both a direct increase in the money supply and a knock-on effect from the fractional reserve system, increasing the money supply further. Although it can involve just making changes to the fractional reserve system, which increases the money supply.

•        QE is usually implemented by a central bank by first crediting its own account with money it creates ex nihilo (“out of nothing”)

•        It then purchases financial assets, for example government bonds, agency debt, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations.

•        It can also involve changing the reserve requirements such that through the fractional reserve system it would increase the money supply.

Explain the impact, including the secondary effects, that Quantitative Easing is likely to have on the: Bond market and Equity market Bond market

Primary

•        QE will likely directly impact the bond market due to the purchasing of bonds by the central bank – driving up prices and driving down yields.

•        Speculation by market participants is likely to exacerbate this impact as speculators try to front-run the central bank.

•        Those who sell government bonds to the central bank will likely want to purchase other bonds in their place.

•        Central banks, such as the ECB and BOJ have begun to also directly purchase non-government bonds, meaning that there will also be a direct impact on those markets.

Secondary impacts

•        The secondary impact will be that more corporate bonds are issued to take advantage of the lower yields and lower financing costs.

•        This may moderate the increase in prices and decrease in yields in the bond markets.

•        In the longer-term the additional issuance could lead to higher inflation due to increased economic activity.

Equities market

Primary impacts

•        Those who sell their assets to the central banks, e.g. their bonds or corporate bonds, will receive cash.

•        Due to low yields they will typically want to invest the cash in equities and other higher yielding assets.

•        This is likely to be result in rising prices for equities and other risky assets

Secondary impacts

•        Companies are likely to use the lower bond yields to issue more bonds for share buybacks.

•        Companies may also refinance existing debt at lower yields.

•        This is likely to lead to increased growth prospects and increased corporate profitability due to lower financing costs.

Explain why Quantitative Easing may lead to an asset price bubble

Approach 1 (Quantity Theory of Money)

•        The Quantity Theory of Money states that MV = PQ where M is the money supply, V is the velocity of money (usually assumed constant in the simple model), P = price levels and Q is overall output.  

•        QE results in a bigger M – this needs to be balanced by a bigger P or bigger Q.  

•        QE has not resulted in any significant economic growth so the Q increase has been quite limited.  

•        So the balancing effect needs to mostly come from bigger P.  

•        An asset bubble would be created when most of the bigger P has come from higher asset prices rather than higher goods prices.

 Approach 2 (supply-demand arguments)

•        QE is likely to distort prices artificially by the significant asset purchases and knock-on impacts.  

•        QE is likely to push asset prices away from their fair values. Lower bond yields are also likely to push the discount rate used in equity valuation below their long-term fair values further distorting prices.  

•        Whether it leads to an asset bubble depends on the size and the duration of the distortion to prices created by QE.  

•        The greater the size of the QE asset purchases, and the longer their duration, the great the risk of a bubble arising.

  Suggest, with reasons, why such an asset bubble might burst.

If an asset bubble arises, it might burst due to:

•        An ending of the QE asset purchasing, removing the artificial distortion to the asset prices.

•        Prices getting so far above their fair values that the weight of market selling becomes bigger than the weight of purchases created by QE.  

•        The QE narrative might evolve creating greater real understanding of its impacts resulting in a greater degree of selling of the overpriced assets.  

•        A significant event, e.g. a Lehman Brothers style collapse event, might trigger a loss of confidence in central banks.  

•        Increased inflation from QE may result in an interest rate or currency response.

 Tutorial 1

Is Bitcoin money?

•        Money has three roles in a modern economy and it is efficient if the same thing (i.e. currency) can deliver on all three roles. Does Bitcoin do this?

•        Store of value

o   Something that will retain it value in a predictable way over time without perishing, so that transactions planned for a later date can rely on the store holding its value until then.  

o   Bitcoin is not a reliable store of value, it can perish e.g. lose your access passwords. Also speculative values at present rather than predictable. So can’t plan ahead for future transactions.  

•        Unit of account

o   An agreed unit value so that all transactions have a common reference point for valuation.  

o   Bitcoin unit value is observable due to trading market information but not stable and no agreed value (more like a share than a unit of currency)  

•        Medium of exchange

o   Something that has the ability to be swapped (traded), and everyone is prepared to use it for this purpose  

o   Bitcoin is a accepted as a medium of exchange by some, but by no means everyone.  

•        Conclusion is Bitcoin is not generally accepted as money but may develop the required characteristics over time.

  Using a home loan for $350,000 as the example, explain how money is created and destroyed.

•        Commercial banks make new loans (eg the home mortgage)

•        The bank credits the mortgage holder (property buyer) with a deposit into an account in their name held at the bank, creating money

•        The amount is then transferred to an account held by the entity selling the house to conclude the property transaction’

•        The seller has received the money (and holds in a deposit with their bank)

•        Mortgage holder is left with a debt to the bank

•        The seller now has money on deposit (new money), the buyer has a property and a liability (loan value) and the bank has an asset (loan value)

•        As the buyer pays off their loan, the bank’s asset declines, money is destroyed.

[sfactuary]

Asset Liability Management

2. MODELLING AND PARADIGMS

2.1 Introduction

2.1.1        Thinking about the detail

•        Ex 2.1 Read the case study and produce a one-paragraph summary that shows you have thought about the issues raised.

Reddington queried the implicit assumptions in the formal expression of calculating present value of cash-flows. Reversing the present value process required the investor to obtain the exact interest specified in the present value calculation and this is almost impossible in practice. Thus, the word ‘interest’ was used both in the physical sense (i.e. a rate quoted by an entity) and the everyday actuarial jargon of a hypothetical quantity used to calculate a present value. Separating these two quantities allowed him to develop the algebra for his theory of immunisation.

•        Need to critically analyse methods, models and assumptions. It is important to not only perform calculations correctly, but to also tell the story behind the numbers.

•        Need to understand why a method is chosen for a problem and learn to question whether the underlying assumptions are valid/justifiable.

2.2     Generic modelling framework

•        The general modelling framework as applied to investment advice is an example of the control cycle in action. The framework requires:

o   data (e.g. past returns, liability profile of the investor);

o   a method that defines how to assess the risk and return drivers;

o   assumptions about the future;

o   a model that can perform the calculations;

o   output of the results;

o   a comparison of what was expected and what occurred;

o   communication of results;

o   a feedback mechanism to update assumptions; and

o   an overarching governance process

•        e.g. portfolio construction will require a model to capture the interaction between A&L, therefore mismatches.

•        Model is affected by assumptions, data and methods. And also professional requirements and an external environment

•       

2.2.1        Models

•        Model is a mathematical representation of a real-world phenomenon, therefore required to simplify the assumptions about real world.

•        The model also needs to be calibrated to the phenomena it is supposed to represent.

•        Degree of simplification will depend on the purpose of the model.

o   LI pricing model use some broad asset assumptions (e.g. constant future returns), as more refined asset model would not materially affect the derived prices

o   Building a model to advocate investment in a new and complicated asset class, such as emerging market private credit, could involve multiple extensive models including:

§  Detailed investigation into each model’s sensitivities to the parameters that would be required

§  Detailed communications on how to manage the risk exposures to help decision-makers decide whether to proceed with the proposed investment

•        Model’s calculations need to be reviewed technically and peer reviewed for materiality.

•        Randomness when modelling the future: all actuarial models are stochastic (uncertain future and events are random). But those models are simplified to be deterministic. E.g. pricing a savings product that has no investment guarantees, assume 6%pa as a mean return on underlying assets, but actual returns will not be constant. Randomness of outcomes are captures via stress testing deterministic model.

•        Types of deterministic sensitive testing

o   Apply fixed % stress test to test the sensitivity of each assumptions

o   Apply a stress test to material assumptions in line with the uncertainty in those assumptions

•        Stochastic investment models are used widely nowadays. Materiality and ability to select future distributions needs to be considered.

•        Ex 2.2:

o   Deterministic models:

§  Pricing insurance contracts where investment returns are not material (e.g. term insurance, ST GI, PHI)

§  Pricing investment linked business (unit linked) where the sensitivity to investment returns are usually captured through sensitivity testing.

§  Valuing a DB scheme in a merger or takeover.

o   Stochastic models:

§  Valuing a guarantee that depends on the path of investment returns. E.g. a stochastic model is required if an investment-linked contract offered the return of the original investment at a specified future date.

§  Calculating the required amount of capital for an insurer so that the insurer is 99.9% certain they can survive for a specified time.

§  Using a stochastic mortality model when considering the risks in offering lifetime annuities.

•        All the models require parameters (assumptions) and data which affects output quality.

•        Deliverables can be restricted by time, labour and IT systems.

2.2.2        Assumptions

•        The general process for selecting and deriving assumptions is:

o   the parameters (i.e. assumptions) of the model are identified through a mixture of factual knowledge (e.g. examining an Investment Product Disclosure Statement and historical data) and experience

o   the assumptions are quantified as arising from statistical distributions and either a single value is selected for ‘deterministic’ models or the full distribution is retained for a stochastic model

o   the quantification process (ACC) involves considering:

§  the purpose of the advice;

§  government intervention via prudential regulations, taxation, or other legislation;

§  the quality of data available;

§  the materiality of an assumption; and

§  how the future will differ from the past, especially considering the external environment and how that may change;

o   assumptions may be changed as experience is obtained; and

o   experience may suggest that other assumptions are required

•        Models with implicit assumptions e.g. using inflation-linked bonds as a solution for hedging against domestic-relate cash outflows lined by inflation implicitly assumes there is enough supply/ liquidity and access to such instruments in the domestic market in practice.

•        Sources of uncertainty when making assumptions

o   Values for assumptions are deducted from an observed sample rather than population

o   Assumptions are derived from old data and then adjusted for future time period where it is uncertain about size and direction of adjustments

•        Investment advice models for LI and retirement schemes are often represent mean outcomes but some require 99.5% CI level.

2.2.3 Data

•        Have regulations on the disclosure

•        Ex 2.3 Issues that may arise if the source of investment return data and timing are not disclosed to retail investors:

o   May be illegal not to disclose and hence the company may be reprimanded by a regulator, face a fine, and possibly lose some brand integrity through negative media releases.

o   If the source is not disclosed, then the user, or other interested third parties such as trade press, cannot check the accuracy of the data.

o   There is the danger that the timing chosen by the company ‘cherry-picked’ dates that made published returns look good.

•        Historical returns are examined to help justify future returns and as a proxy for experience.

2.2.4 Professionalism

•        All actuarial work should be completed in adherence to the local actuarial standards and expected professional behaviours

•        Actuary should be comfortable to defend their work in a court of law in public or media.

•        Actuary should ensure that they are competent with knowledge and skills in relevant area to complete the task.

•        Ex 2.4: You work as an enterprise risk actuary on life insurance products. Your company has a small business division that provides actuarial services to defined benefit (DB) schemes and has one actuary who signs off on reports. He has recently taken six months of paternity leave. You have been asked to transfer to the business division to provide sign-off on defined benefit ALM reports. Discuss your choices.

You have a number of options available to you. Which option you decide to exercise will depend on your specific circumstances as well as your previous experience in other roles before this. The options could be, but are not limited to:

•        Decline to take up the responsibilities. This is particularly appropriate if you do not possess the required experience and/or knowledge and are unable to get the required support to be effective in your new role.

•        Accept the role, but with the condition that appropriate use will be made of subject-matter experts to provide comfort and guidance in performing your duties. This can potentially be through external consultants as there has only been one actuary internally in the past who signed off.

•        Accept outright. If you have performed similar roles in the past and are comfortable that you still have the required knowledge and expertise (and that these are reflective of current best practice), then it could be appropriate to take on the role.

The ethical considerations should also be clearly understood before exercising an option, such as whether a potential conflict of interest exists or even just the perception of such a conflict, between this role and the usual role performed. This will ensure that reasonable steps are taken to meet policyholders’ reasonable expectations and that the appropriate care is taken in signing off the DB reports.

Your work may well be peer reviewed or audited or reviewed by a regulator — you need to be able to show the reviewer that you have the professional competencies required and your work complies with all professional requirements. These considerations should be made before accepting the role, not after accepting the role and delivering the reports.

It is worth pointing out that if you take responsibility and problems arise (e.g. the wrong thing happens either due to bad luck or negligence), then the quality of your work will be peer reviewed by other actuaries who are subject experts and they may appear as expert witnesses in a potential court case. These peers will critique your judgement and the decisions you made even on very technical matters, so you should keep this in mind if you decide to accept full responsibility for the task. Remember, you can be held accountable, even for complex subject matter.

2.2.5 External environment

•        E.g. applicable regulations and taxation rules

•        Insurers can influence internal factors such as expense costs and policyholder behaviour (e.g. contacting lapsed customers to reinstate their policy), but actual market investment returns are largely external to insurers or superfund decisions.

2.3     Investment paradigms

•        Need to understand both side of the arguments e.g. theories and approaches

2.3.1 Long-Term Capital Management hedge fund

•        LTCM was a hedge fund led by Wall St bond traders and Nobel prize winners

•        Used complex mathematical models to derive huge returns

•        Before 1997, Held $30 debt to every $1 capital with high leverage of 25:1

•        When Russia devalued its currency and defaulting on its bonds, i.e. liquidity crisis and made leverage of 250:1 making the fund vulnerable to shocks

•        Fund lost 44% of its value by Aug-1997. Federal reserve gathered 11 banks to bail out LTCM

•        Assumptions include:

o   Sovereign states will not default on bonds or currency

o   Perfect market liquidity – the flight to quality was not foreseen

o   Returns follow the normal dist’n – price changes were rapid and well outside plausible scenarios under normal dist’n

2.3.2        Causation and correlation Background

•        Pearson correlation coef: Cov(X,Y)/√[Var(X) x Var(Y)]. The measurement is an indication of the linearity of the relationship, but it is not always capable of evaluating the strength of the relationship

•        The Pearson correlation coefficient, lies between -1 and 1, has the following limitations in evaluating the strength of relationship between two or more variables:

o   it does not capture nonlinear effects;

o   if the knowledge of one random variable provides exact information about another random variable, then the correlation coefficient may still take any value between -1 and 1;

o   the correlation coefficient may be quite different under monotonic transformations of the variables— for example, the correlation coefficient of X and Y may be different from the correlation coefficient of log(X) and log(Y); and

o   some insurance risks are heavy tailed, with potentially infinite variances, making the Pearson correlation coefficient indeterminable.

•        It can be overcome by the Spearman rank correlation coefficient (‘Spearman Rho’) and the Kendal rank correlation coefficient (‘Kendall’s Tau’). These are non-parametric methods that do not depend on the marginal distributions of the underlying risk variables. The rank coefficient methods are less affected by outliers compared with the Pearson method.

Causation

•        Issues with above 3 correlation methods:

o   They are numerical measure of dependency but do not fully characterise the dependency structure

o   Independent rvs have 0 correlation, but doesn’t mean they are independent

•        If correlated, possible relationships include:

o   A causes B

o   B causes A

o   A and B are consequences of common cause but not of each other

o   A causes B and B causes A

o   There is no correlation b/w A and B, it is a coincidence

•        Correlation does not imply causality i.e. past data might show correlation but does not mean they are causally linked

•        If A causes B, 3 conditions must be satisfied:

o   A must precede B

o   B occurs iff A occurs

o   There are no other causes or effects

•        If there is causal relationship, then we can assume it’ll continue in future – causal law

•        It not causal relationships and can only observe historic correlation – historical regularity

•        Example: shares outperform bonds over long periods (supported historically), but it is not universally agreed.

o   There are periods where this is not the case.

o   But the long term relationship: Return on equities = real return on bonds plus inflation plus equity risk premium (ERP)

o   Why did shares outperform bonds in that period? Why will that reason be valid in the future?

•        Ex 2.5: Your studies of Life Contingencies would have introduced you to Gombertz’s law of mortality. That law assumed that the force of mortality increased with age. Makeham refined the law through the addition of a constant that allowed for an age independent rate of accidental death. Perks (1932) generalised those laws with an upper limit to the rate of mortality. An expression for Perks’s law is 𝜇𝑥= 𝐴 + 𝐵𝑒𝜌𝑥 /(1+𝐶𝑒𝜌𝑥).

In practice, the differences among the three laws are not numerically material except at young or old ages, although they are clearly different from a scientific viewpoint. Is Perks’s law a law of nature or a regularity?

Numerical values will have to be derived from observed data for the parameters — and be invariant in the future. We know that mortality rates have been improving for all ages for many years, except for recent data in the UK suggesting a fall in life expectancy. This suggests a regularity rather than a law of nature.

 The form of the law is based on these three conditions:

1. Whilst it appears true that the force of mortality will increase with age, one has to find evidence that the force of mortality is of the suggested analytically tractable form.

2. The force of mortality may reach a limiting value but that appears to vary over time.

3. There is a constant mortality rate representing accidental deaths — which is a good first approximation over many age ranges. (The suicide rates for males in 2018, per 100,000 of population, were 20.2 (ages 15–24), 22.7 (ages 25–34), 25.6 (ages 35–44), 27.5 (ages 45–55) and 24.9 (ages 56–65). The figures do not appear in the top 10 causes of death for older age groups because of the rapid rise in death from other causes.)

 More importantly, we need to identify a cause for the force of mortality in the form expressed in Perks’s law. Given the multitude of causes of death, changes in medical knowledge, and lifestyles, it seems more likely that the law is an artefact of fitting data to observations. The laws were derived in times where calculations were much more laborious than today. We may use the ‘law’ but should note that it is a regularity derived from data rather than a natural physical law.

2.3.3        The philosophy of Thomas Kuhn

•        In 1962, Kuhn proposed that science does not develop in a linear manner.

•        The science progresses in various stages:

o   Pre-science: lack of agreement over fundamentals

o   Normal science: work of scientists who improve accepted theories

§  Paradigm – the entire constellation of beliefs, values, techniques and so on shares by scientific community. Paradigm include: clearly stated fundamental laws with associate assumptions; agreed methods of applying the fundamental laws; and definitions of measurable quantities and how to measure quantities.

§  Normal science assumptions: type of questions that are deemed relevant to the field of study; the process by which these questions are studies; and how results are interpreted.

§  Normal science progresses by solving puzzles within the framework of the paradigm

§  When odd results are encountered, the researcher will question whether they did something wrong

o   Crisis: if anomalies question the validity of the fundamentals of a paradigm and cannot be explained away

o   Revolution: occurs when scientist start to lose confidence in paradigm

o   New normal science: lead by new paradigm to reject the old one (called paradigm shift)

o   New crisis

The process of normal science, the accumulation of anomalies, the move into a scientific crisis, and the paradigm shift are collectively labelled by Kuhn as a scientific revolution.

•        Social and cultural norms and incentives may reduce objectivity of scientific output. Scientists may be reluctant to give up on paradigms due to either rejecting until a new/ better one developed or don’t want their work and expertise to become irrelevant and superseded by others. Therefore, paradigm-shifts might take time – a generation or longer.

2.3.4        Exemplars

•        Concrete problem-solving solutions that students encounter throughout their scientific education

•        Assumptions that are taught make is not the case in real world e.g. the assumption that stock returns are independent, identically distributed, log-normal random variables.

•        Ex 2.6 Exemplars used in Foundation:

o   the Black–Scholes model

o   using q(x) as a deterministic function;

o   believing that the version of the central limit theorem is the only version whereas the conditions taught in Foundation (IID and finite variance) may be relaxed;

o   the existence of the risk-free rate

o   risk-free rate invariant by duration

o   a focus on parametric probability laws.

2.3.5        Duhem-Quine thesis

•        It argues that no scientific hypothesis is by itself capable of making predictions. Instead, deriving predictions from the hypothesis typically requires background assumptions that several other hypotheses are correct.

•        Collection of background assumptions and hypothesis – bundle of hypotheses

•        It says that it is impossible to isolate a single hypothesis in the bundle

•        The evidence might be insufficient to make a decision e.g. insufficient data to give conclusions

•        The Duhem–Quine thesis, also called the Duhem–Quine problem, after Pierre Duhem and Willard Van Orman Quine, is that it is impossible to test a scientific hypothesis in isolation, because an empirical test of the hypothesis requires one or more background assumptions (also called auxiliary assumptions or auxiliary hypotheses).

•        The Duhem–Quine thesis argues that no scientific hypothesis is by itself capable of making predictions. Instead, deriving predictions from the hypothesis typically requires background assumptions that several other hypotheses are correct — that an experiment works as predicted, or that previous scientific theory is accurate.

•        Ex 2.7: E.g. where actuaries make conclusions using limited data.

In general, actuaries advise decision-makers on potential consequences of decisions. The data is often not sufficient to make a 100% accurate prediction, but that is not the focus of actuarial advice.

For example, consider the output from an experience investigation into lapses across a portfolio of policies.

Policies will be suitably grouped into homogeneous groups (e.g. by age, duration, premium size, gender, etc.). The actual experience for each group can be compared with the expected broad-brush results for each group. A series of ratios of actual/expected are tabulated, possibly showing trends in prior years. These tables are then used to assess whether changes to expected rates for the future are necessary. The data contains significant amounts of noise, which often makes it difficult to obtain clear signals. It is the role of an experienced actuary to determine the need, and implications, of any change to the assumptions.

2.3.6        Historical development of investment theory

•        Technical analysis

o   Charting (19th century)

o   Method to estimate short-term movements in asset prices based on an examination of past prices and trading volumes

o   Assumes there is a correlation between past price movements and trading volumes with future price movements.

•        Fundamental analysis (1934+)

o   Attempts to derive the intrinsic value of an asset by analysing the factors that could affect its price in the future.

o   Uses financial statements, past trends in data, compared with companies in similar industries as well as external factors.

o   Intrinsic value will not be same as current market price but using it an analyst may derive an intrinsic value that will lead to buying, selling or continuing to hold a stock.

•        Modern portfolio theory (1952+)

o   Alternative to mean-variance analysis (trade-off between the return on a portfolio and variance –‘risk’)

o   Ideas developed: investors were making rational decisions; the equity risk premium as the reason why investors purchased risky assets; volatility as a proxy for risk; and correlation across assets — the ‘beta’ as part of the Capital Asset Pricing Model.

o   Current prices reflect all current market information

•        Behavioural finance (1979+ with Prospect theory)

o   Investors aim to achieve maximum utility – more is preferred to less

o   Explains actual investor behaviour. Affected by biases and act irrationally.

 2.4     Governance

•        Investment governance and investment management are different.

•        Governance is focused on defining the objective, key roles, and responsibilities and reviewing progress towards achieving the objective.

•        Management is concerned with the implementation and execution of the plan.

•        General approach to investment governance structures for institutional investors:

o   Investment committee: BoD with external investment specialist appointed for their expertise.

o   Investment staff: BoD appoints internal committee for investment governance responsibilities

o   Third party or external resources

•        The Board is responsible for purpose, philosophy and goals made with input from committee and staff. They also delegate responsibilities with varying accountabilities depending on factors:

o   Size of the organisation and FUM

o   Knowledge, skills, experience and capabilities of investment staff

o   Amount of time investment staff can devote, especially if they have competing priorities

o   Number of staff and depth of the team, considering business continuity, costs, efficiency and succession planning

2.5     Qualitative aspects

•        For actuarial advise, consider quantitative techniques (what and when) and qualitative questions (why and how)

•        It is important to see if past events will be replicated in the future. E.g.

o   When sample data is small, non-existent, or not reliable to build statistical distributions for the assumptions

o   Law of large numbers may be used to show the sample mean coverages to the true underlying mean, assuming its underlying distribution is stationary which is not true.

•        Risk is when outcome is unknown, but probability of the outcome is definable. Uncertainty applies when we are incapable of having sufficient information to formulate a probability (unknown unknowns).

•        A/L modelling is uncertainty.

2.6     Key learning points

•        The examination questions will expect you to develop clear, concise, and coherent arguments to support the claims that you may make.

•        A model is a mathematical representation of real-world problems and involves simplifying assumptions that must be calibrated against the real world.

•        Even if results are sometimes presented as a single deterministic outcome, most actuarial problems and models are stochastic because the future is uncertain, and events are random.

•        Data is critical to actuarial work and the actuary must consider the accuracy of data and comment on data issues.

•        Assumptions need to be appropriate for future experience. In setting assumptions, historical data and experience and the interpretation of emerging trends are important.

•        All actuarial work should be completed professionally and in accordance with required standards and expected behaviours.

•        An actuary as a professional advisor must consider not just quantitative techniques and the delivery of numerical answers, but also answer qualitative questions. The implications of the numbers you produce must be carefully explained to decision makers.

•        Actuarial work must also consider relevant wider issues and trends in society.

•        Correlation does not imply causality — are past observations merely a historical record or will they occur in the future?

•        Normal science progresses by solving puzzles within the framework of the agreed paradigm.

•        The accumulation of anomalies may push science out of ‘normal science’ into a scientific crisis.

•        A new paradigm, which would lead to new normal science, must emerge before the old one is rejected. The move from paradigm to another is called a ‘paradigm shift’.

•        Exemplars are concrete problem-solving solutions that students encounter throughout their scientific education and may entrench paradigms.

•        The Duhem–Quine thesis argues that no scientific hypothesis is by itself capable of making predictions, because background assumptions are required.

•        There are multiple paradigms in investments, suggesting that the subject is in a ‘crisis’.

•        Investment governance is focused on defining the objective, key roles, and responsibilities and reviewing progress towards achieving the objective.

•        Investment management is concerned with the implementation and execution of the plan decided by the governance process.

•        Risks can be defined as applying to situations where the outcome is unknown, but the probability of the outcome is definable; and uncertainty as applying where we cannot obtain sufficient information to formulate a probability.

[sfactuary]

Asset Liability Management

1.    INTRODUCTION

·  ��      While the mathematical emphasis in the subject is important, it should be borne in mind that mathematical techniques alone can have limited success. Failure can arise from inappropriate models, assumptions, and data.

·         This subject will cover seven broad areas:

•        an understanding of the characteristics of the three main asset classes — bonds, equities and property. We look at characteristics by considering the:

§  security (i.e. credit risk);

§  yield (e.g. real/nominal, expected return/running yield relative to other assets);

§  spread (i.e. volatility of market values);

§  term (e.g. short/ medium/ long, or defined/undefined);

§  expenses (i.e. dealing and management);

§  exchange rate (i.e. currency risk);

§  marketability;

§  liquidity; and

§  tax

•        a discussion on how money is created in the banking system: In the modern economy, money is largely created by retail banks issuing loans.

•        an overview of the valuation of bonds, equities and property: how those asset classes are managed. A detailed description of the valuation process for portfolio management and stock selection.

•        the use of derivatives as hedging instruments: to understand how contracts are managed in financial markets

•        a critique of investment theories: Module 2 provides an overview of ideas from the philosophy of science that will help students understand how to frame the problems of investment theories discussed in Module 8.

•        likely long-term investment returns: and associated risks and uncertainties, is a significant component when pricing and valuing many types of long-term insurance and retirement products

•        the process of selecting assets to match liabilities:

§  advising on suitable investment objectives for organisations or individuals;

§  advising on strategic asset allocations; and

§  designing, developing, running, and monitoring an asset liability model.