Category Archives: market risk

What is best practice for matching annuities in Greece in 2012?

Best practice for matching non-profit annuities in most countries, certainly from a risk perspective, is still to cash flow match (or at the very least, match key durations) using government bonds.

The theory is that the insurer isn’t then exposed to changes in the term structure on interest rates, only exposed to illiqudity/reinvestment risk to the extent of mortality fluctuations, isn’t exposed to currency risk and certainly isn’t exposed to credit risk. Without complex margining requirements like some swaps and without the need to roll cash investments over, government bonds should allow ALM teams to sleep well.

Now, Solvency II is likely to adopt a swap yield curve rather than bond yield curve. There are some good reasons here, including arguably fewer distortions from temporary supply and demand imbalances, improved liquidity and so on. The same yield curve is used for liquid liabilities so the allowance for an illiquidity premium over and above the swap curve at some times, in some ways and for some products is still under debate.

But what should Greek insurers do in the meantime?

Frankly, Greek government bonds don’t remove credit risk and the huge credit spreads on these instruments will create huge funding gaps and variability in earnings unless a Greek govi yield curve is used to value liabilities as well. It’s not clear at all that Greece will stay part of the Euro, so German government bonds don’t remove currency risk. German government bonds in any case are show signs of nervousness as yields creep up.

The swap market is exposed to the same Euro break-up risks as bonds. Which banks will survive, what happens to currencies in the meantime and what does that do to long-term Euro swaps? What about Euro-Sterling swaps issued by Greek banks (I’m not sure if these even exist though).

All in all, it’s good to be involved in ALM in South Africa, and even the Middle East just at the moment.

Greek default?

So European politicians have more or less agreed a deal which may, more or less, push some of their problems to one side for a period. Yes, I’m not madly optimistic about this as a cure-all.  This is not the end of the Euro problems.

Part of the deal is a “50% loss for private investors”. Which is part true and part nonsense but will be an effective Greek default when enacted / agreed. (I don’t care how “voluntary” it may be, it’s a default and almost all definitions of default include restructuring of debt in any way that isn’t what was originally promised.)

Why is it only partly true? Well it’s not necessarily a “loss” for private investors. The probability of default on Greek bonds has been just about 100% for a while now. This probability of default is derived from market prices for Greek bonds and market spreads on Greek Credit Default Swaps (CDS) and an assumed Loss Given Default or Recovery Rate for investors when the bonds do default. Actual Recovery Rates vary widely, but often analysts plug in the average Recovery Rate over most of this century on unsecured debt which is around 40%.

So if market prices for Greek bonds assumed 100% default probability and a 40% recovery, then a 50% recovery doesn’t sound so bad. The potential downside is that Greece may still (need to) default on these written-down bonds at some point in the next two decades.

So the real question is what will the new probability of default be? Then we will know whether investors “took a loss” and perhaps gain the market’s view on how successful the deal really will be.

Golden Stories

Gold has had a fantastic run, getting to within sight of $2,000 recently. Many see this as a clear indication of hyper inflationary pressures arising out of loose monetary policy. The informed recognise that you can’t have hyperinflation if all sensible measures of actual prices other than a particular, volatile commodity are showing very low inflation.

Some stories about gold today and recently:

Now I don’t spend much time on gold as an investment, but these stories are certainly interesting.

I’ll leave you with one thought (for the OMG! Inflation! of my readers).  If the gold price is a measure of “real prices” in the economy, but prices of actual goods and services are more or less unchanged in dollar terms, this means the price of these items in gold terms has plummeted massively. Do you really think that a scenario where all prices are half of what they were two years ago is workable? What should have to wages? What needs to happen to wages? What will likely actually happen to wages? Does any part of this scenario seem like a Good Thing?

Surveys, papers and books on the ERP

Some interesting papers on the ERP:

Market Risk Premium used in 56 countries in 2011: a survey with 6,014 answers

The Equity Premium in 150 Textbooks

Equity Premium: Historical, Expected, Required and Implied

  • This work provides a fairly in-depth analysis of the differences between the various definitions of ERP and a comprehensive survey of major sources for estimates of these. In general, the estimates of the Expected ERP over T-bonds (rather than short-dated T-bills) are in line with the range I use of 3% to 5% with several showing values to the lower end of this range.
The debate certainly isn’t over, but these papers and the referenced papers, research and textbooks are a good starting place to get up to speed.





Book Review: This Time is Different

This Time Is Different: Eight Centuries of Financial Folly is a fascinating look at 8 centuries of financial crises including banking, currency and sovereign default.

It’s chock-full of analysis, numbers, tables and charts showing how as much as things change, the scope for financial crises changes very little.  The comparison of Developed and Emerging Markets is particularly interesting in that the differences, while they do exist, are far smaller than stereotypical views.  Emerging Markets do tend to have more ongoing sovereign defaults, but the frequency of banking crises is little different. Weirdly, some aspects of Emerging Market crises (such as employment impacts) are less than average for the Developed World.

It isn’t really the book’s fault, but this was one of the few books that I struggled with on my kindle – the graphs and charts and captions to figures were particularly difficult to read. Perhaps they would look better on the Kindle DX (the larger model) or even an iPad or something.

Although the book doesn’t focus on the current (still-happening, if you weren’t paying attention) financial crisis, there are several chapters dedicated to it with an analysis of the economic indicators leading up to the crash. Now it’s incredibly easy to predict an event after it’s happened, but I’m still hopeful that the results can be useful in predicting future problems and potentially impacting economic policies and regulations for the better.

Some key conclusions from the book for predictors of financial crises:

  • markedly raising asset prices (yes, and in particular house prices given the likely co-factor of increases in debt levels)
  • slowing real economic activity
  • large current account deficits
  • sustained debt build-ups (public and/or private)
  • large and sustained capital inflows to a country
  • financial sector liberalisation or innovation Continue reading Book Review: This Time is Different

The Alpha and Inflation of Commodities

Commodity prices rise and the world screams hyperinflation.

Elsewhere, alternative investment managers espouse the virtues of commodities as an asset class that generates “alpha” returns (i.e. returns not related to the overall direction of markets). The thing is, it’s hard to have it both ways.  The link between unexpected/expected inflation and equity prices in the short- and long-run is complicated.  High inflation grows earnings in nominal terms, which should grow equity prices in nominal terms. High inflation often leads to higher interest rates and a reduction in money supply through decisions by central banks to put a break on inflation. These higher interest rates stifle the economy and can lead to decreases in earnings, which will give rise to lower share prices ceteris paribus. Built-in inflation expectations where monetary policy is fairly predictable will probably give rise to high nominal equity market returns (but probably not high real returns as inflation has a frictional cost on the economy which often surpasses any gains from real wage declines.)

So if commodity inflation was linked to core price inflation, we would expect a much stronger link between commodities and equities. (Yes, there are a million more points to consider here and not all support this hypothesis.) (Also, obviously as an input into broad measures such as consumer price inflation commodity prices increase that measure, but the point is there is limited knock-on effect on other prices, so core inflation which typically excludes volatile energy and food prices is hardly moved. It’s core inflation that is a strongly autoregressive time series.)

But better than all that, the smarter, better education (and certainly more focussed) people at the Chicago Fed had put together a pretty compelling research paper on commodity prices and inflation (pdf). Check it out.

Commodity prices rise and the world screams hyperinflation. Of course they’re wrong.

Fixed Interest is a viable asset class

I heard someone talking on Classic Business tonight. Pity I didn’t catch his name so I can avoid his advice in future.

He was saying that he doesn’t see the point in investing in debt instruments.  He explained that the return is low and the risk high since if the company gets into trouble, you’ll likely only get a few cents on the dollar back.

Well, he’s wrong.

Risk and asset-liability matching

Fixed Interest investments are often the only investment that makes sense when you need to match or hedge fixed liabilities.  Naively consdering expected return only and not asset-liability risks  gives naive results.

Credit risk premia more than compensate for default experience over time

It’s worth exploring risk a little further. The caller stated that if the company gets into trouble, it’s likely the bondholders will also be hurt, and will likely only get a few cents on the dollar. Well he’s wrong here too.

The historical default frequency for investment great bonds (BBB and above) has been hardly more than a few single digit percent.  The Loss Given Default (how much an investor will typically lose if the bond issuer does default) is anywhere from 35% to 80%, depending on the seniority of the instrument, which estimate you trust, how it is measured and when the estimate was made. It’s because there are so few investment grade defaults that the data is so sparse and the estimates so wide. However, it’s clear that the likely return won’t be “a few cents on the dollar”.

I’m going to hunt round for some references here so you’re not just trusting my word.

Illiquidity premia = higher returns for some

Given the illiquidity of many corporate bonds, the expected returns are even higher if you as an investors are not considered with easy liquidation of your investment. This is a “pure risk premium” that you will earn over time without expected loss.  You could purchase extremely high quality, well-collateralised debt and earn a good return above risk-free as long as you have the patience and resources to hold it for long periods or until maturity.