Cardano Seminar

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Liability driven risk management
strategies Tailor made or one size fits all?
Zürich, November 8th, 2005
Roel Menken www.cardano-riskmanagement.com
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Content

• ALM Strategic derivative solutions
• ALM objectives
• Case Pension fund specific strategies
• Hedging of interest rate risk
• Hedging of extreme risks in the equity portfolio
• Strategic derivatives solutions implementation

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Controls within Risk Asset ManagementMore
emphasis on the strategic use of derivatives in
ALM
Optimise hedge interest inflation risk
Modern asset allocation (further diversification)
Active Financial Risk Management
Optimised in the 1990s
Reduce extreme risk of the risky assets
Foreign exposure hedge
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ALM Objectives

• The ALM objectives are dependent of the nature
  and the overall objectives of the institution,
  e.g.
• Ability to pay future liabilities
• Protection of the value of the investment
  portfolio
• Inflation protection
• Growth objectives
• Assets, liabilities and ALM objectives should be
  modelled in order to determine the optimal hedge
  strategy, e.g.
• Analysis of effects of protection strategies for
  interest rate risk and inflation risk
• Analysis of strategies to protect the extreme
  risks in the equity portfolio
• Optimization of the asset mix

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Tailor-made vs standardized approach

• Institutions can chose between standardized
  liability driven investment products as well as
  tailor made hedge strategies
• Tailor made hedge strategies are more effective
  but require more operational efforts
• Standardized products are easier to implement but
  tend to be sub-optimal and more expensive
• Which approach is optimal is dependent on the
  seize, the profile, the level of sophistication
  and the preferences of the of the institution

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Case studyIllustration of pension fund
solutions
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Illustration of pension fund solutionsCase study
of fund specific derivatives strategies

• Case based on typical pension fund
• Special (Dutch) feature Conditional indexation!
• Analysis of optimal long term ALM strategy taking
  objectives and constraints into account
• All liability calculations based on Fair Value
• Focus on funding level risks
• Contribution rate is assumed to be constant
• In practice attention is also paid to indexation
  and pension risks

Case concerns existing but slightly modified
pension fund
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Hedging interest rate riskAnalysed strategies in
case study

• Interest rate swaps
• Interest rate options (e.g. swaptions)
• Swaptions, especially in case of interest rates
  below long term mean reversion levels
• Interest rate dependent combination of swaps and
  swaptions
• In case of low interest rates ? swaptions
• In case of normal or high interest rates ?
  interest rate swap
• ? optimal risk return trade off

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Hedging interest rate risk Nominal swaps
Probability of underfunding, 30 years
Probability of underfunding, 10 years
60 equity
60 equity 40 bonds
without swaps
without swaps
60
40
40
60
20 equity
20
40
Nominal swaps
Nominal swaps
40
20 equity
20 equity 80 bonds
Average funding ratio
Average funding ratio
Interest rate risk reduced by means of interest
rate swap Remaining risk drivers equity and, to
a lesser extend, inflation
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Interest rate dependent strategyLow interest
rates swaption, high interest rates swap
Probability of underfunding, 10 years horizon
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60 equity 40 bonds
without swaps
nominal swaps
60
40
60
20
low interest ratesswaptions high interest rates
swaps
40
40
20
20 equity 80 bonds
Average funding ratio
In a mean reversion envirionment, an interest
rate dependent swaption/swap strategy is more
efficient than a swap strategy
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Hedging equity risk

• Equity options can be applied for hedging extreme
  risks in equity portfolios and reduce solvency
  requirements
• Variation possible in
• Option type, maturity, strike level, underlying
  variable, volume etc.
• Rollover strategy (for example staggered
  structure)
• Optimal derivative strategy strongly depends on
  structure of pension fund, e.g.
• Maturity,
• Contribution rate policy
• Indexation policy
• Asset allocation

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Equity derivatives in ALMResults of tailor made
equity options
Probability of underfunding, 10 years
Probability of underfunding, 1 year
60
60 equity
nominalswaps
nominal swaps
40
70
70
40
nominal swaps tailor made equity options
nominal swaps tailor made equity options
20
50
20
50
30
30
Average funding ratio
Average funding ratio
Tailor made equity option strategy reduces risk
efficiently on a short as well as a long horizon
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Strategic derivative solutionsImplementation
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Implementation process

• Implementation consists of three inseparable
  processes followed by ongoing support

transaction implementation
practical specification
ongoing support
operational implementation
Transaction and operational implementation can
be carried out simultaneously.
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Practical specificationSome examples

• Fine-tuning of liability hedge based up (nominal
  or real) interest rate sensitivity per time
  bucket
• Stagger derivative maturities in order to prevent
  impact of extreme market conditions with
  roll-over
• If applicable modification of strike level used
  in ALM study based up difference between total
  return index and price (dividend paying) index
• Incorporating current FX risk strategy into
  option structure
• Etc. etc.

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Transaction implementation

• Decision of protective derivative structure based
  on Asset Liability study

Transaction implementation process
Transaction specification and documentation
Supplier selection
Price negotiations and execution
Trade, check and preparation of confirmation
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Transaction implementationSpecification and
documentation

• Term sheet
• To ensure correct product specification
• To ensure comparable quote requests
• ISDA Master and Schedule
• Framework contracts
• Specification of definitions
• Credit Support Annex (CSA)
• Agreement to post collateral under a transaction

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Transaction implementationSupplier selection

• Selection of product suppliers based on
• Price
• Product specialisation
• Creditworthiness
• Possibilities to mitigate credit risk
• Reputation and commitment
• Correct and timely confirmations

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Transaction implementationPrices on OTC market
not always arbitrage free
Indication relative to theoretical
price Percentage of notional
0.50
0.25
All prices within a range of 10 basis points
0.0
-0.25
Prices converge towards trade date and are close
to theoretical (offer)price
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Operational implementation

• Correct deal capture
• Back office reports

Administration

• Validated models, checked by external accountant
• Market parameters independent from product
  suppliers

Accounting / valuation
Operational implementation process

• Risk exposure overview
• PL explanation

Control risk management

• Reduction of credit risk
• Collateral reports

Collateral management
Procedures and external supervision

• Processes properly documented (AO/IC)
• Information to external regulator

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From ALM to operational implementation
Ongoing support
Modeling derivativesstrategies in ALM
Intermediation andimplementation

• Selecting counterparties, price negotiations,
  documentation process
• Credit risk management, collateral
  management, documentation, legal issues
• Derivatives valuation and PL decomposition
• Tailored derivatives trainings

• Determining risk exposure with stochastic
  ALM modeling
• Optimization with derivatives in a in a
  risk/return context

• Collateral management
• Continuous input of non public available
  market data
• Maintenance of valuation and reporting tools
• Accounting control
• Periodical evaluation of hedges
• Roll on and rebalancing activities

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Summary

• Focus is shifting from asset only towards asset
  liability management
• Standard products as well as tailor made hedge
  strategies can be applied to meet the ALM
  objectives
• Which approach is optimal is dependent on the
  seize, the profile, the level of sophistication
  and the preferences of the of the institution
• Interest rate risk and extreme risk in the equity
  portfolio can be reduced substantially with the
  strategic use of derivatives
• Proper management of the whole process from
  modeling to implementation is key

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Cardano contact
Cardano Risk Management Beurs World Trade
Center P/O Box 30173 3001 DD Rotterdam The
Netherlands Telephone [phone]
47 Fax [phone] E-mail info_at_cardano-ri
skmanagement.com Website www.cardano-riskmanagem
ent.com Board Theo Kocken Huub van
Capelleveen Roel Menken