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Developing an investment strategy (2) (pure matching (timing or amount of…
Developing an investment strategy (2)
pure matching
timing or amount of asset proceeds or liability outgo may be uncertain
involves buying excessive amounts of certain securities
generally requires risk free zero coupon bonds with exactly same term as liabs, which do not normally exist, or are too expensive
suitably long-dated assets do not exist
ALM
deterministic or stochastic model that can be used to help an institutional investor set an investment strategy.
model will have a specified objective with a measurable target that refers to assets and liabs, a time horizon and a probability confidence interval.
liability hedging
assets are chosen in such a way as to perform in the same way as the liabs
immunisation
PV (assets)-PV (liabilities) is immune to a general small change in the rate of interest
problems
possibility of mismatching profits removed
theory only works for small interest rate changes and assumes a flat yield curve and level interest rate changes at all terms
dealing costs and taxes ignored
assets of a suitably long discounted mean term may not exist
timing of asset proceeds and liability outgo may not be known
risk budgeting
the process of establishing how much risk should be taken and where it is most efficient to take the risk
how to allocate maximum permitted overall risk between active risk, structural and strategic risk
strategic risk
risk of underperformance if the strategic benchmark does not match the liabilities
structural risk
risk of underperformance if the sum of the individual benchmarks given to the fund managers does not add up to the strategic benchmark
active risk
risk of underperformance if the fund managers do not invest exactly in line with the individual benchmarks they are given
measures
historic tracking error
forward-looking tracking error
allocating the active risk budget across the component portfolios
MVPT with liabilities, including surplus formula
Minimise variance of surplus for a given expected return
S= A Σ xi (1+Ri) - L