Organised by

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THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
Welcome Address
The Rt. Hon. The Lord Mayor, Alderman David Brewer
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
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THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
Welcome Address
Professor David Rhind, CBE
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
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THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
Introductory Address
Professor Costas Th. Grammenos, OBE
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
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THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
Keynote Speaker
Dr. Supachai Panitchpakdi
(Secretary General, UNCTAD)
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
5
THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
World Economy and Business
Mr. Andrew Gowers
(Former Editor, Financial Times)
on
"A world in Search of Leadership"
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
6
THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
World Economy and Business
Stelios
(Chairman, easyGroup)
on
Why Should Governments Encourage
Entrepreneurship?
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
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THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
World Economy and Business
Dr. Robert Ting-Jieh Chu
(President, Taiwan An Feng Steel Group)
on
"China Taiwan The Uncertain Future"
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
9
China and Taiwan the uncertain future ????? -
??????
10
Taiwan Miracle?

• From high inflation in the 1950s to achieve
  stability in the 1960s since then started to
  take off.
• From agricultural society to Newly 30
  Industrialized Country within 30 years It took
  100 years for Europe and the US, 70 years for
  Japan.
• From wholly relying on American help to achieve
  self-dependent
• Overcome lack of natural sources and small
  domestic market, in 1970s, it achieved trade
  surplus and in the 1980s, Taiwan became the 11th
  export country in the world
• Taiwanese government started to achieve
  non-deficit in the 1970s.

11
Taiwan Miracle?

• The unemployment rate was lower than 2 for 30
  years, 1967-1996
• From a very poor country to reach GDP per head of
  USD 6000, In 2005, Taiwan overseas investment
  exceeds USD 387.1 billion, ranks No 4 in the
  world
• From labour-intensive industries to become world
  leaders in information and technology industries

12
The Hong Kong Handover

• In 1997, as Britain prepared to return control of
  Hong Kong to China, Taiwan conducted live
  military exercises in the Straits. Experts said
  it was to demonstrate that Taiwan would not
  quietly follow the Hong Kong example. The United
  States began shipping fighter jets to Taiwan that
  year, and on the island itself the
  pro-independence Democratic Progressive Party won
  municipal elections.
• In 1999, President Lee announced that Taiwan
  enjoyed a "special state-to-state relationship"
  with China. This statement of implied state
  sovereignty angered Beijing. Taipei backed away
  from the position, but talks between the two
  leaderships were cut off.

13
Taiwan Politics

• In 1999, as Taiwan prepared for its next
  presidential election, three candidates appeared
  close in the polls, Premier Zhu Rongji threatened
  "bloodshed" if the Taiwanese voters "acted on
  impulse." Though he did not directly say it, the
  statement was pointed at supporters of Chen,
  whose party calls for independence.
• Despite the veiled threats, Chen won narrowly by
  310,000 votes, collecting 39.3 percent of the
  vote. For the first time in 50 years, a
  non-nationalist KMT party leader would take the
  helm in Taiwan. Some Taiwanese said they rallied
  behind Chen in the wake of China's threats.
  Others liked his pledge to defeat corruption.

14
Taiwan Politics

• In 2004, Chen again faced intense competition
  from the KMTs (Nationalist Party) Lien.
• This time, he was shot one day before the vote.
  The government activated the National Security
  Code which means many people work for national
  security, army and police will not be able to
  vote.
• The result was that Mr. Chen won the election by
  29518 votes which are representing 0.23 of valid
  votes. Invalid votes are 337297, 2.35 of votes
  cast.

15
Transition of Industries
SourceITIS
16
Taiwan
Exports - partners China, including Hong Kong
37, US 16, Japan 7.7 (2004) Imports -
partners Japan 26, US 13, China, including
Hong Kong 11, South Korea 6.9 (2004)
17
China

• ? 2004, FDI 60.6 billion USD
• (Since 1996, total 562 billion USD)
• FDI , 71 Manufacturing, 10 property
• 63 export growth is contributed by foreign
  companies.
• No 6th economy in the world, 3rd trading country
• Taiwan is its second import trading partner.

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Economic Fortunes ??????

• A countrys economic fortunes are determined by a
  combination of
• Nature geography, given factors as the mean
  temperature, humidity, the prevalence of disease,
  soil quality, proximity to the sea, latitude and
  mineral resources
• Nurture human action, history, institutions

20
Taiwan as No. 1
SourceIEK
21
2005 Taiwans Top Brands
Source BNext, Taiwan
22
Ranking of Competitiveness2004
Source World Economic Forum
23
Countries that attract FDI
????World Investment Report (UNCTAD)
24
Foreign Investment in Taiwans Stock Market

• 2001 19.14
• 2002 15
• 2003 22.5
• 2004 24
• 2005 29.26 (Stock market capitalisation USD
  420 Billion)

25
WTO China and Taiwan
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Trade between China and Taiwan

• In 2004, Taiwan had trade surplus of USD 51.2
  billion to China
• Without this surplus, Taiwan trade balance will
  negative, the overall economic growth rate will
  decrease 1.9 . We can say that trade will China
  ONLY help the overall economy of Taiwan and help
  increase employment rate.
• This surplus brings around USD 256 million tax
  income.

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GDP Growth of Four Asia Dragons 2000 2005

• Korea 5.4
• Hong Kong 4.7
• Singapore 4.1
• Taiwan 3.3

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The Foundation of National Development

• ???? Geography
• ?? Institution
• ?????????????? ????????
• ?? Policy

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Korea VS. Taiwan

• Face the Competition from China but also have the
  opportunity to enter the China market.
• No political issues and Korea can go on with long
  term planning
• Taiwan has the language and culture advantage
• Korea has acquired 12 of the Chinese Market in
  2004.
• 10 years ago, Taiwans GDP was well above Korea
  by 2154USD. After the Asian Financial Crisis,
  the Korean GDP went down to 7400. But now, they
  are almost the same.
• Taiwan has been marginalised, where to go?

34
China and Hong Kong- CEPA

• The third stage - 1369 of products tax-free (374-
  713 1369)
• Including law and financial services etc.
• 2004, Hong Kong attracted 4260000 people from
  China, who spent USD 6.5 billion. This created
  20000 jobs.

35
Three Future Crisis

• Oil it has net import of 50, it may face energy
  crisis in the future
• Financial Risks Bank bad loan 1.8 trillion
  debt of local government 1 trillion, of GDP
  10 underground finance has reached a very high
  percentage of national economy
• The divide between poor and rich within 20
  years, there are 300 million people from country
  side to go to city

36
Taiwan policy towards China

• Many, but

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A society characterized generalized reciprocity
is more efficient than a distrustful society
Trustworthiness lubricates social life. Frequent
interaction among a diverse set of people tends
to produce a norm of generalized reciprocity.
Civic engagement and social capital entail mutual
obligation and responsibility for action
Sometimes social capital like its conceptual
cousin community sounds warm and cuddly.

Robert Putnam (2000)
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We come from all the divisions, ranks and classes
of society to teach and to be taught in our
tern. While we mingle together in these pursuits,
we shall learn to know each other more
intimately we shall remove many of the
prejudices which ignorance or partial
acquaintance with each other had fostered
Thomas Greene (1829)
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The Future of Taiwan

• Recognize the modern trend (China) to find out
  its new economic positionUnderstand that China
  has been transforming from world factory to
  world market
• Involve in international affairs
• Education
• Develop Taiwans Social Capital

41
Large Economies/TNCs (billion of dollars)
42
Cooperation

• 2005 Nobel Prize in Economics, Schelling and
  Auman, Game Theory
• utilizing mutual expectations to make
  compromise and by working together to solve all
  kinds of conflicts
• ???????
• ????????????????????????????

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THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
World Economy and Business
The Hon. Apurv Bagri
(Managing Director, Metdist Ltd.)
on
"India - The Story of a Powerhouse"
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
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THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
World Economy and Business
The Lord Griffiths of Fforestfach
(Vice-Chairman, Goldman Sachs Ltd.)
on
"The Challenge for the G8 of Implementing Gleneagl
es"
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
46
THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
World Economy and Business
Prof. Julius Weinberg
(City University)
on
"Pandemic Influenza The Economic Impact"
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
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• Julius Weinberg
• ProVice Chancellor
• Director Institute of Health Sciences
• City University

48
Pandemic Influenza

• Virology

Influenza A, B, C
Disease of Birds
H5N1
49

• Within any Influenza Strain for example the H3N2
  that current circulates there can be lots of
  variants.
• Antigenic Drift H and/or N change enough so you
  can get flu again

50

• Antigenic Shift
• A completely new virus appears
• 1. Bird Virus and Human Virus mix
• - possibly in pig, possibly in man
• 2. Bird Virus mutates

51

• 1968 3 Human 5 Bird genes
• 34,000 U.S. deaths and 700,000 deaths worldwide
• .
• 1957 3 Human 5 Bird genes
• 70,000 U.S. deaths and 1-2 million deaths
  worldwide
• 1918 Pure Bird
• 500,000 U.S. deaths and up to 40 million deaths
  worldwide

52
H5N1

• Circulating widely in Birds in SE Asia
• Unlikely to be eradicated
• High Chance of Bird Virus Human Contact
• Has shown ability to infect Humans
• No Person to Person Spread

53
Costs

• 1994 locally-contained outbreak of plague in
  Surat, India, estimated cost of US2 billion
• cholera outbreak in Peru cost the countrys.
  economy an estimated US 770 millionin lost.
  trade and travel income.
• 1997 Avian Flu in Hong Kong estimated to have
  cost hundreds of millions of dollars in lost
  poultry production, commerce and tourism.
• 2003 SARS estimated 60 billion cost to South and
  East Asia Economies

54
SARS

• There were approximately 800 deaths - and thus no
  discernible impact on output
• actual economic losses were estimated at 0.5
  percent of annual East Asian GDP in 2003
• Concentrated in the second quarter of the year,
  when there was a much sharper loss of around 2
  percent of quarterly GDP.
• (Note that a 2 percent loss of global GDP during
  an influenza pandemic would represent around 800
  billion per year).
• Why such a severe economic loss?
• People tried to minimize face-to-face
  interactions.
• The result was a severe demand shock for services
  sectors such as tourism, mass transportation,
  retail sales, hotels and restaurants.
• Business costs increased due to workplace
  absenteeism, disruption of production processes
  and shifts to more costly procedures .

55
Influenza

• if 15 of the American population were to fall
  ill, the economic cost might amount to 93
  billion. If 35 were to succumb, the cost would
  rise to 217 billion.
• Economist

56
Influenza

• Aon, an American insurance broker and risk
  consultant states, broadly speaking, a pandemic
  will be an uninsured event. Employee shortages
  are likely and Aon suggests that companies should
  assume 25 of workers could fall ill
• ? What happens to the food chain if 25 of HGV
  drivers are off

57
H5N1 Costs

• The continuing outbreaks that began in late 2003
  and early 2004 have been disastrous for the
  poultry industry in South-east Asia by mid-2005,
  more than 140 million birds had died or been
  destroyed and losses to the poultry industry are
  estimated to be in excess of US10 billion.
• Vietnam, one of the most seriously affected
  countries, some 44 million birds or 17 percent of
  the total population of poultry, were culled at
  an estimated cost of 120 million (0.3 percent of
  GDP).

58
1957

• In 1957, up to 50 of British schoolchildren
  developed influenza,
• In residential schools in the UK, attack rates
  reached 90, often affecting the whole school
  within a fortnight.
• In Liverpool in 1957 12.6-19.4 of nurses were
  absent during the first 4 weeks of the epidemic
  in one hospital, nearly a third were absent at
  the peak.
• During September and October 1957, the two main
  months of the epidemic in the UK, it was
  estimated between 25,000 and 30,000 more cases of
  acute respiratory infection were admitted to NHS
  hospitals in England and Wales than would have
  been expected at that time of year.
• Hospital admission and bed bureaux could barely
  cope with the demand placed upon them.

59
20??

• For an 8 week period
• 25 workforce off
• In UK at height 1Million people a day falling
  ill
• 50,000 deaths (conservative)
• Cost worldwide 2 GDP 800Billion

60
Costs (direct and indirect) of influenza pandemic
per gross attack ratein 1995 US
Meltzer, Emerging Infectious Disease 2005
61
costs to the United Kingdom

• Illness-related absenteeism from work could take
  3 billion to 7 billion off GDP
• Excess mortality could take a further 1 billion
  (0.37 percent mortality) to 7 billion (2.5
  percent mortality) off GDP
• Loss of future lifetime earnings could cost in
  the longer term anything from 21 billion to 172
  billion.

62
Are We Prepared

• IOD survey showed that only 50 percent of member
  companies had contingency plans in place
• the lack of planning was particularly marked
  among smaller companies.
• compounded by the lack of resilience in a whole
  range of services that are critical to business,
• partly as a result of the fact that for very
  good economic reasons and very good business
  reasons, we have taken much of the slack out of
  our systems in many sectors.

63
What can we do

• Invest in early detection
• Intervention might work before there are c50
  cases in a rural area
• Flight restrictions unlikely to work
• Better vaccines 8 months to produce a vaccine
• Better and more antivirals
• Modelling of Social restrictions

64
THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
Financial Markets
Mr. Thomas Huertas
(Director, Wholesale Firms and Banking Sector
leader, The Financial Services Authority)
on
"Major Issues of the 21st Century Financial
Markets"
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
65
Major Issues of the 21st CenturyFinancial
Markets Fourth City of London Biennial Meeting,
5-6 December 2005

• Dr. Thomas F. Huertas
• Financial Services Authority

66
Limited opportunities for domestic UK growth

• UK is mature economy
• Growth comes from pushing out the envelope of new
  technology and raising productivity
• This is inherently harder than rebuilding a
  war-torn economy or eliminating structural
  barriers
• Real interest rate is approximately equal to
  long-term rate of potential growth in per capita
  GDP
• But UK has a wealth gap to sustain living
  standards as population ages, UK must generate
  wealth at a faster rate than the rate of growth
  of real GDP

UK real risk-free interest rate is below 1
Yield on 50-year index-linked UK-government gilt
Source DMO
67
Go East Old Man?

• The UK will account for only 5 of total growth
  in global output over the next twenty years.
• Developing countries will account for nearly
  half.
• Over two thirds of the growth in developing
  countries will come from just four countries
  Brazil, Russia, India and China
• These countries have much higher potential
  returns on investment (but also higher risk) than
  is likely to be available in the UK
• Is part of the solution to closing the UK wealth
  gap greater direct and portfolio investment in
  the BRIC countries and/or developing countries
  generally?

BRIC countries will grow most rapidly
Distribution of Worlds GDP (2004100) Source
extrapolation of current growth rates from World
Bank, World Development Report
68
Finance forges UK wealth
The UK has a comparative advantage in finance,
and finance is one of the most important
industries in the UK. Finance facilitates access
for UK savers/investors to global growth
opportunities. Facilitating access for UK
investors to growth opportunities allows UK based
finance to do the same for savers/investors in
other countries. This further strengthens the UK
economy. Preserving and enhancing the attractive
UK environment for finance is therefore key to
sustaining UK growth and to closing the wealth
gap.
London is the worlds most attractive financial
centre
Source Corporation of London, November 2005
69
THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
Financial Markets
Mr. Wilber Colmerauer
(Director, Liability Solutions)
on
"Hedge Fund Risks Myths"
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
70
Hedge Fund Risks Myths
Wilber Colmerauer Liability Solutions December
2005
71
US 1,200 Billion Each
No Sign of Consolidation
72
Perception

• Turbo Charged
• High Fees
• Micro Organizations
• Lack of Transparency
• Prone to Fraud

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Reality

• Hedge Means Hedge
• Bond Substitute
• Institutional Product
• Leverage Not Endemic
• Shorting Not Endemic

75
Return of Hedge Funds Bonds Equities
76
Relative Volatility
77
Hedge Profile

• Positive Returns
• Limited Capacity
• Flexible Mandate

78
Investor Profiles

• Fund Partners
• Family Friends
• Ex-Employers
• Family Offices
• Fund of Funds

• Charities
• Governments
• Pension Funds
• Foundations
• Insurance Companies

79
Retail Vehicles

• Performance
• Capital Guaranteed
• Leverage
• Distributors or Managers

80
Hedge Fund Risk

• Market Impact
• Bonds
• Equities
• Commodities
• Currencies
• Derivatives
• Volume Impact Small

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Investor Risk

• Fund Fraud
• Volatility (overstated)
• Mis-selling of Packaged Products
• Overpriced Insurance

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WHAT TYPE OF HEDGE FUNDS
83
Sector Appropriate For Portfolio?
Reviewing Info-Material
Initial Meeting Or Conf Call
Peer Group Analysis
New HF Manager

• HF Database
• HF Journals
• Introduction
• Recommendation
• Conference
• Cold Call from HFM

• Marketing
• Performance
• Other Info Data

• Categorization
• Statistical Analysis

No
Files
Questionnaire
Desk Research Report
Internal Presentation
Due Diligence Report
Onsite Meeting

• Preparation for onsite Meeting
• Quant Analysis
• Return Assessment
• Risk Catalogue
• References
• 8 Ps

• Verification
• Operation
• People
• Trading/Execution
• Final discussion
• Open questions

• Team
• Product
• Process
• Performance
• Organization
• Portfolio
• Peer
• Potential

• Presentation of HFM by analyst
• Discussion within Investment Committee

HFM Rating By Committee

• Strong Buy
• Buy
• Watch List
• Not recommended

84
DUE DILIGENCE IN FUND OF HEDGE FUNDS MAIN
CRITERIA
85
THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
Financial Markets
Prof. Harry Kat
(Cass Business School)
on
Replication of Hedge Fund Returns
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
86
Replicating Hedge Fund ReturnsHarry M.
KatAlternative Investment Research CentreSir
John Cass Business School, City University,
LondonE-mail Harry_at_AIRC.info
87
Hedge Fund Replication

• Why Replicate Hedge Fund Returns?
• - Lack of transparency
• - Lack of liquidity
• - Lack of capacity
• - Excessive fees
• - Annoying managers
• - Style drift

88
Hedge Fund Replication

• What Exactly Do We Mean by Replication?
• Hedge fund return generating processes are
  extremely complex. Accurate replication of
  month-to-month returns is therefore not possible.
  
• Fortunately, from an investment perspective there
  is no real need to replicate month-to-month
  returns.
• It is typically enough to replicate the
  statistical properties of a funds returns.

89
Hedge Fund Replication

• Our Goal Therefore Is
• To design a dynamic trading strategy, trading
  stocks, bonds, etc., that over time generates
  returns with the same statistical properties as
  the fund to be replicated.
• Returns may come in a different order but will
  need to exhibit similar volatility,
  skewness, correlation, etc. properties as the
  fund.

90
Hedge Fund Replication

• Hedging/Pricing Options
• 1. Determine options payoff function (payoff as
  a function of the reference index).
• 2. Design dynamic trading strategy, trading the
  index and cash, that generates the same payoff as
  the option under all possible scenarios.
• 3. Executing the strategy will hedge sale of the
  option.
• This idea is used by banks all over the world to
  hedge trillions worth of options positions. It
  works!

91
Hedge Fund Replication

• Call Option Payoff Function

92
Hedge Fund Replication

• From Payoffs to Return Distributions
• Payoff function in combination with distribution
  of the reference index implies a return
  distribution.
• Reverse reasoning If you can find a payoff
  function that implies the desired return
  distribution then you can generate that
  distribution by generating that payoff.

93
Hedge Fund Replication

• What Assets to Trade?
• Cash - to move money through time.
• Reserve asset the main source of uncertainty.
• Investors portfolio - to match the relationship
  between fund return and portfolio return.

94
Hedge Fund Replication

• The General Replication Procedure
• Collect return data on fund, portfolio and
  reserve asset.
• Analyze data and decide on desired bivariate
  distribution
• Derive payoff function generating desired
  distribution
• Derive dynamic hedging strategy from payoff
  function
• Execute strategy

95
Hedge Fund Replication

• Performance Out-of-Sample Test
• Monthly hedge fund return data from TASS database
• Assume first 24 months of data are given.
• Assume investors portfolio consists of 50 SP
  500 and 50 T-bonds.
• Trade SP 500 and T-bond futures for replication.
• Use Eurodollar futures as the reserve asset

96
Hedge Fund Replication

• Example 1 A well-known Fund of Hedge Funds

97
Hedge Fund Replication

• Example 1 A well-known Fund of Hedge Funds

98
Hedge Fund Replication

• Example 1 A well-known Fund of Hedge Funds

99
Hedge Fund Replication

• Example 1 A well-known Fund of Hedge Funds

100
Hedge Fund Replication

• Example 2 A well-known Convertible Arbitrage
  fund

101
Hedge Fund Replication

• Example 2 A well-known Convertible Arbitrage
  fund

102
Hedge Fund Replication

• Example 2 A well-known Convertible Arbitrage
  fund

103
Hedge Fund Replication

• Example 2 A well-known Convertible Arbitrage
  fund

104
Hedge Fund Replication

• Example 3 A well-known Short Seller

105
Hedge Fund Replication

• Example 3 A well-known Short Seller

106
Hedge Fund Replication

• Example 3 A well-known Short Seller

107
Hedge Fund Replication

• Example 3 A well-known Short Seller

108
Hedge Fund Replication

• Other Applications of the Same Technology
• Evaluation of funds
• If we can generate returns with the same risk
  characteristics but with a higher mean return,
  then the fund in question is inefficient.
• Creation of funds
• We do not need real-life data for the procedure
  to work. Investors can simply specify what they
  want and the procedure will generate a trading
  strategy with the desired characteristics.

109
Hedge Fund Replication

• Conclusions
• Using dynamic trading technology it is possible
  to generate returns with similar statistical
  properties as hedge funds (of funds)
• Replication avoids many of the problems
  associated with alternative investments and is
  therefore to be preferred over the real thing.
• The same technology can be used to create funds
  that optimally fit into an investors portfolio,
  irrespective whether such a fund already exists
  or not.

110

• For research papers visit the Alternative
  Investment Research Centre website at
• www.cass.city.ac.uk/airc

111
THE FOURTH CITY OF LONDON BIENNIAL MEETING
6th 7th, December 2005
Financial Markets
Prof. David Blake
(Cass Business School)
on
Major Issues of the 21st Century Ageing in the
Financial Markets
Organised by City University, London, and its
Cass Business School
Sponsored by Maria Tsakos Foundation
112
Major Issues of the 21st Century Ageing and the
Financial Markets

• Professor David Blake
• Pensions Institute
• Cass Business School

113
Ageing

• Worlds population is ageing rapidly
• Due to
• Increasing longevity
• Declining fertility
• Another critical factor is longevity risk
• Increasing uncertainty attached to length of life

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115
Linear improvements in life expectancy since the
1840s
116
Consequences of ageing

• Big financial burden passed to next generation,
  via
• public pension system
• health care system
• Will next generation accept this burden?
• Or will it break the intergenerational solidarity
  pact and move to low tax countries?

117
Consequences of ageing

• Pension funds mature and move from accumulation
  phase to distribution phase
• Requirement for assets generating regular and
  reliable cash flows increase
• Demand for bonds increase
• Demand for equities falls

118
Consequences of ageing

• How will companies respond?
• Suppose companies respond by
• buying back shares
• issuing bonds in their place
• Modigliani-Miller Theorem tells us that this will
  not change total corporate risk
• Therefore the corporate bonds become as risky as
  the equity
• In aggregate pension funds cannot reduce risk by
  switching out of shares into bonds

119
Consequences of ageing

• Even worse, risk could increase
• Since corporate bond holders can force company
  into insolvency in a way equity holders cannot

120
Consequences of ageing

• How else might companies respond?
• To reduce risk of insolvency, they might engage
  in less risky investment projects
• Will global risk taking fall as the worlds
  population ages?

121
Stochastic nature of mortality improvements

• Evident for many years that mortality rates have
  been evolving in apparently stochastic fashion.
• Sequences do exhibit general trend, but changes
  have an unpredictable element
• not only from one period to next
• but also over the long run.

122
Mortality improvements over time

123
Mortality improvements over time

124
Longevity risk

• Large number of products in life insurance and
  pensions have mortality as key source of risk.
• Products exposed to unanticipated changes over
  time in mortality rates of relevant reference
  populations.

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Longevity risk

• Eg annuity providers exposed to risk that
  mortality rates of pensioners will fall at faster
  rate than accounted for in pricing and reserving
  calculations
• Current pool of annuitants living 2 years longer
  than anticipated

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Longevity risk

• Annuities are commoditised products selling on
  basis of price, profit margins have to be kept
  low in order to gain market share.
• If mortality assumption built into price of
  annuities turn out to be gross overestimate, cuts
  straight into profit margins of annuity
  providers.
• Most life companies claim to lose money on
  annuity business.

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Longevity risk

• Yet life annuities are mainstay of pension plans
  throughout the world
• they are the only instrument ever devised capable
  of hedging longevity risk.
• Without them, pension plans will be unable to
  perform their fundamental task of protecting
  retirees from outliving their resources for
  however long they live.
• Real danger that they might disappear from
  financial scene.

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Significant concern!

• Reinsurers (eg Swiss Re) have stopped reinsuring
  longevity risk of life offices!

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Longevity bonds to the rescue!

• Life annuity bond coupon payments decline in
  line with mortality index
• Eg based on population of 65-year olds on issue
  date.
• As population cohort dies out, coupon payments
  decline, but continue in payment until the entire
  cohort dies.
• Eg, if after one year 1.5 of population has died
  out, 2nd years coupon payment is 98.5 of 1st
  years etc

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Problem

• Natural shortage on supply side
• Very few institutions have natural longevity
  hedges in their balance sheets
• One example would be pharmaceuticals
• So is there a role for Government to issue
  longevity bonds?
• Government is Insurer of Last Resort
• By issuing longevity bonds, Government could help
  create a missing market

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Conclusion

• Existence of longevity bonds
• will facilitate the development of annuities
  markets in the developing world
• and could well save annuities markets in the
  developed world from extinction.
• They will be the NEW product of the 21st century!