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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