Risk-free interest rate workshop - PowerPoint Presentation

Slide1

Risk-free interest rate workshop

Brian KippsSlide2

Swaps vs. Bonds: Theoretical considerations

In evaluating an ideal “risk free” yield curve one should consider the

characteristics required

from such a curve:

Observable

Transparent, quoted in the open market, easily validated

Objective

No bias in the curve or data used in constructing the curve. Typically this is achieved in cases where there are a significant amount of contributors

No/low credit risk

Projected

cashflows

should be discounted at a rate which implies that there is certainty on the occurrence of such

cashflow

Liquidity across term structure

Liquidity indicates the reliability of the observed prices/rates and whether observed rates are achievable. In the valuation of long-term liabilities it is important that there is liquidity across the term structure of the yield curve due to the sensitivity of long-dated

cashflows

to interest rates.

Arm’s length requirement

Typically used in defining a fair value: should indicate the price or value at which such valued

cashflows

could be bought/sold in the financial markets.Slide3

But let’s be clear:

there is no true risk free curve

– governments default despite the ability to print cash and raise

taxes (that is why

SA local currency debt is only A- on international scale), and collateralised swap transactions can lose money if a bank defaults and you can’t close out the transaction quickly enough and collateral proves insufficient (jump risk)What we really need is a practical approach to the risk free rate and to move on to some of the more important stuff

Swaps vs. Bonds: Theoretical considerations (cont)

Ideal characteristics

Bond Curve

Swap Curve

Observable





Objective





No/Low

credit

Risk





Liquid across term structure





Arm’s length transaction



Slide4

Using

a

specific

risk free curve

in the insurance industry could have significant implications for local financial markets:Government relies on the bond market for funding, especially in the back end which is where long term insurers invest although bank support through B3 as well as real money investors will arguably absorb the supply should the swap curve be preferredCorporates and banks rely on the swap market for funding and risk transfer through the derivatives market, again long term insurers play an important role hereAnd since neither curve is truly risk free, why do something that has wider unintended consequences on the real economy?First prize is that insurers are allowed to use either the swap curve or the bond curve in valuing different tranches of business as this will ensure minimal impact on or disruption to the financial markets

There may need to be rules to prevent abuse of this e.g. upfront election per tranche of business (not unlike an accounting election), and capital implications for assuming bond/swap basis risk in risk management activities

Swaps vs. Bonds: Practical implicationsSlide5

It is also very important to consider the

illiquidity premium

as part of our risk free rate discussion

Remember a bond is

funded (your money is at risk), whilst a swap is unfunded (no cash put down) and collateralised under CSAA bond (adjusted for credit risk) is comparable to a bank deposit (adjusted for a bank’s credit risk), and not a swapBank deposits pay significantly over Jibar to attract term funding, the majority of which is compensation for illiquidity (banks need to pay investors a premium to lock up their funding so they have a stable deposit base to on-lend to corporates)A bank raising funding through senior debt (marked against government bonds), or through institutional deposits (marked against

Jibar) is generally ambivalent between the two sources – they are priced to be largely equivalent, and in fact a bank will generally swap its senior debt funding into Jibar once it is raised anyway

What this means is that there is a big

market force

(bank funding) ensuring that the government bond and (credit adjusted) deposit markets are kept in line

Supply and demand dynamics of the two markets means this does not always hold, but there is a link between the two of them

Swaps vs. Bonds: Practical implications (cont)Slide6

In the event that a

single risk free curve

is forced upon the insurance industry, then in our opinion the

swap curve is preferable

:Closer to credit risk free: CSAs internationally moving to zero threshold, cash collateralisedConvergence of banking and insurance: if we want to reduce regulatory inconsistencies, then we need to adopt the swap curve – why should a 5yr amortising deposit have a different value to a 5yr term certain annuity?For the economy: supports corporates looking to fix their funding, whilst B3 and real money investors will continue to support government funding effortsFor fixed income liabilities: Interest rate risk is an unrewarded risk; credit risk is a rewarded risk. Swaps allow flexibility to hedge interest rate risk, but optimise allocation to credit risky assets – beneficial to policyholder returns and/or shareholder ROEFor hedging of investment guarantees

: Some exposures cannot be hedged on the bond curve – no swaptions

, zero coupon instruments, and funding implications would force you into a rolling bond forward strategy which is expensive (which will impact policyholder pricing and benefit provision)

and is dependent on the bond-repo market at every roll date

Arms

length: if the intention is to create a market consistent liability, the market consists of other life companies and banks (which use the swap curve) – not the

government

Swaps vs. Bonds: Practical implications (cont)Slide7

Illiquidity premium

= compensation for locking your money in for a long period of time

For an annuitant, he is

lending

his money to the life company for a long period of time and deserves compensation for this – this can be achieved by investing his money in matching assets which earn an illiquidity premium e.g. long-dated bonds, loansAn illiquidity premium is merely one constituent of the overall risk premium defined as the total return on an asset in excess of the risk free returnCredit spreads are generally defined as the spread over risk-free on a credit risky asset. Credit spreads are not in their entirety compensation for expected loss – they also compensate the investor for illiquidity, profit (to cover CoC)

Illiquidity premium

Total risk premium

Total return on asset

Compensation for non firm-specific credit risk.

Profits demanded by investors.

Compensation for firm-specific credit risk.

Compensation for potential lack of liquidity.

Bond or swap

rate.

Total risk premium

Idiosyncratic default risk premium

Systemic default risk premium

Illiquidity premium

Excess risk premium

Risk free returnSlide8

So how do we

approximate

this illiquidity premium, since on its own it is not easily observable...

Ideally the illiquidity

premium is calculated from the market, not from the assets you hold – this is old school actuarial thinkingA practical suggestion:If using the swap curve, look at bank funding rates and adjust for bank’s credit risk If using government curve, apply something similar to current matching premium calculation but calculated on a universe of applicable bonds, not just the ones you happen to hold, and adjusted using expected loss rather than random number like 25%One of the problems with the current matching premium approach is that because it assumes one risk free (swap) curve, it also captures bond/swap basis in the matching premium if you invest in bonds

This has nothing to do with illiquidityTo avoid this, either disallow these assets from the matching premium calculation (not ideal), or strip out the bond/swap basis from the matching premium AND hold capital against the basis risk

Does this really need to be

prescribed

, or just some

principles agreed?

Illiquidity premium (cont)Slide9

In valuing long dated liabilities it is inevitable that these will extend beyond the observable part of the yield curve (roughly 30yrs)

The key principles that should be applied in extrapolating a yield curve are:

Where there is

useful data

, use it (e.g. back-end of observable curve)Ideally no complicated theoretical model which is hard to understand and creates unnecessary “noise” in capital calculations and earnings Convergence to an ultimate forward rate is a sensible approach although care should be taken not to put too much reliance on a few points on the observable yield curve: could lead to market distortionsIdeally the extrapolated part of the curve needs to be linked to the observable yield curve and updated dynamicallyIdeal outcome would be for insurers to apply discretion as long as methodologies are consistently applied, sensible, and (potentially) disclosed

Extrapolation methodologies