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Liability Driven Investment

1b. Introduction: Similarities with other techniques

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1.5          The concepts behind the protection portfolio and the swaps overlay are similar to the actuarial theory of matching. Indeed, if the liabilities are short enough and the trustees want a passively managed low risk approach then 1.3(c) might become superfluous and 1.3(b) might be merely involve a more traditional cash flow matched portfolio using, say, government bonds.

 

1.6          If the current incarnation of LDI can be said to be novel relative to what has gone before, the core ‘new’ idea is the use of swaps or other similar derivatives, within 1.3(c). They are used because the liabilities are typically of too long duration (or, in the case of an insurer hedging guarantees, too complex) to be matched merely using physical bonds. So, we need a ‘synthetic’ method of artificially lengthening the duration of the assets if, for example, we do not want to be exposed to the risk that very long dated yields will fall more than we expect. This is possible using interest rate swaps, particularly long-dated ones. Using swaps also gives the investor a wider range of underlying bonds in which it can invest; indeed the swaps be overlaid on top of the return seeking portfolio as well as the (physical) protection portfolio, potentially allowing investors to invest a higher proportion of their overall portfolio in return-seeking assets than would otherwise be the case (from which they would presumably expect to receive a suitable reward).

 

1.7          The same overall concept is still applicable for the swaps overlay component if the liabilities are CPI linked (or contain other more complex inflation-linked characteristics such as Limited Price Indexation, ‘LPI’) instead of merely involving long dated fixed monetary amounts. Such characteristics are common amongst the liabilities of many types of defined benefit pension scheme. The only real difference of substance is that the cash flows that the swaps pay to the pension fund need to include these features if they are to hedge against such risks, i.e. they need to involve the investment banks selling ‘inflation’ (here used as a shorthand for cash flows with characteristics sensitive to future inflation rates) to the pension fund. Of course, swap counterparties (typically banks) will typically want to hedge their exposures. So they will be on the lookout for other market participants (e.g. utility companies or infrastructure projects) prepared to sell them inflation. The two sides do not need to be in identical form (e.g. one might strictly increase in line with the RPI, the other might be more LPI in nature).  The ‘art’ of good derivatives intermediation is to be able to access both sides of the flow, make a good return between the two and keep the inevitable residual mismatches well controlled and hedged (and to charge an appropriate spread for carrying this risk).

 

1.8          We referred in Section 1.4 to a balance between risk and reward. Investors may also have views on the extent to which different types of risk are more or less ‘expensive’ to hedge, where here ‘expensive’ means extent of potential reward foregone. For example, they may believe that ‘extraneous’ currency exposures within a typical asset portfolio will typically be less well rewarded over the longer term than a bias towards equities (e.g. because they believe that a successful capitalist economy should reward the latter but there is no particular reason to believe that it will reward the former). This may influence the extent to which particular risks are hedged and therefore on the relative sizes of different types of risk exposures catered for in the protection portfolio or swaps overlay.

 


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