HKD peg


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  • If interest rates continue to go down and the US dollar weakens further, we will experience expansionary consequences Even though the Hong Kong economy is booming, the HKMA was forced to cut its base lending rate twice (a total of 75 bps) lower.
  • If interest rates continue to go down and the US dollar weakens further, we will experience expansionary consequences Even though the Hong Kong economy is booming, the HKMA was forced to cut its base lending rate twice (a total of 75 bps) lower.
  • HKD peg

    1. 1. <ul><li>Group 7 </li></ul>The Hong Kong Dollar Peg 03/11/2008 International Finance
    2. 2. AGENDA 1 2 3 4 The Hong Kong Dollar Peg Manulife and the Insurance Industry Risks for Manulife Proposed Strategy 4 1 2 3
    3. 3. The HK Dollar peg This is an old story… US$1=HK$7.80 (for issue and redemption of Certificates of Indebtedness) US$1=HK$7.75 (HKMA undertakes to convert the HKD in licensed banks’ clearing accounts maintained with the HKMA into USD at the fixed exchange rate of HK$7.75 to US$1 US$1=HK$7.80 The rate has been moving to 7.80 by 1 pip each calendar day starting from 1 April 1999 ending 12 August 2000. US$1=HK$7.75–7.85 (May 2005 onwards) HKMA set up upper and lower guaranteed limit since 18 May 2005 4 1 2 3
    4. 4. The HK Dollar peg …that constantly repeats itself Joseph Yam ( HKMA Chief) - September 2006 (1) The US dollar continues to be the appropriate anchor for the Hong Kong dollar for the foreseeable future (2) It is technically not possible for the Renminbi to be a currency anchor (3) No change, therefore, is needed to the Limited Exchange Rate system 4 1 2 3
    5. 5. The HK Dollar peg Why Hong Kong should not be pegged to the USD <ul><li>Hong Kong’s Economy is more linked to China than the USA </li></ul><ul><li>HK consumer sentiment not always matches that of the USA </li></ul><ul><li>Exports to China and Europe could grow, while those to the US do not </li></ul><ul><li>The increased trade with China, the weakening of the HKD against many Asian currencies, the strong inbound tourism and the until recently vibrant financial market are signs of a delinking of Hong Kong from the US developments </li></ul>4 1 2 3
    6. 6. The HK Dollar peg Why Hong Kong should not be pegged to the USD (cnt’d) 4 1 2 3
    7. 7. The HK Dollar peg Why Hong Kong should not be pegged to the USD (cnt’d) <ul><li>US-Dependent Monetary Policy causes Inflation (Asset Bubble?) </li></ul><ul><li>Low interest rates cause increase in money supply in Hong Kong – increase in asset prices and inflation </li></ul>4 1 2 3
    8. 8. The HK Dollar peg Why Hong Kong should not be pegged to the USD (cnt’d) <ul><li>Low Income Households bear the brunt of inflation </li></ul><ul><li>Cost-of-living increases is felt especially by low income families, while those better-off enjoy returns from soaring values of property and financial assets </li></ul><ul><li>Hong Kong has a Gini index of 53.3 (the low income families account more than half of the Hong Kong population) </li></ul><ul><li>Problem of Sterilizing Liquidity in China due to depreciating HKD Assets </li></ul><ul><li>Underground cash channels are used to buy HKD assets with RMB. The depreciation of the HKD further increases these illegal activities </li></ul>4 1 2 3
    9. 9. The HK Dollar peg If not, should it be pegged? And to which currency? <ul><li>Renmimbi </li></ul><ul><li>Not ready – capital account not fully convertible (a key prerequisite for pegging the HKD to the RMB) </li></ul><ul><li>Unproven – untested in times of recession </li></ul><ul><li>No freely floated – what is the right rate? </li></ul><ul><li>Reputation – HK reaffirmed their commitment to the USD peg </li></ul><ul><li>China slowdown is inevitable – decreases in demand from the US would slow down China’s growth contributing to unemployment </li></ul><ul><li>China’s financial markets are under development </li></ul><ul><li>Others </li></ul><ul><li>Cannot peg to the EUR – unproven </li></ul><ul><li>Cannot peg to the JPY – political reasons </li></ul>4 1 2 3
    10. 10. The HK Dollar peg Why Hong Kong should be pegged to the USD <ul><li>USD is stable </li></ul><ul><li>Served HK well until now – reputation for stability </li></ul><ul><li>Still the world’s major currency </li></ul><ul><li>HK trade is more closely correlated to the US than to the Mainland </li></ul><ul><li>Don’t make long-term decisions based on short-term factors </li></ul>Correlations of domestically generated growth and inflation in HK and the Mainland Correlations of growth and inflation in HK and the Mainland generated by US shocks 4 1 2 3
    11. 11. The HK Dollar peg What is the cost of keeping 1 USD = 7.80 HKD? <ul><li>PPP relationship in the relative version </li></ul><ul><li>e = (  USD -  HKD )/(1+  HKD ) ≈  USD –  HKD </li></ul><ul><li>where e is the rate of change in the exchange rate and  USD ,  HKD are the inflation rates in the United States and Hong Kong, respectively </li></ul><ul><li>International Fisher Effect (IFE) </li></ul><ul><li>E(e) = ( i USD -i HKD )/(1+ i HKD ) ≈ i USD -i HKD </li></ul><ul><li>where E(e) is the expected change in exchange rate and i USD , i HKD are the nominal interest rates in the United States and Hong Kong, respectively </li></ul><ul><li>For Hong Kong this means </li></ul><ul><li>There is no room for monetary policy discretion under a fixed exchange rate regime </li></ul><ul><li>For the regime to work robustly, only the interest rate instrument must work to stabilize the exchange rate target </li></ul>4 1 2 3
    12. 12. The HK Dollar peg What is the cost of keeping 1 USD = 7.80 HKD? <ul><li>Monetary policy </li></ul><ul><li>To keep the Hong Kong dollar in a trading band set at HK$7.75-7.85 to the US dollar, the Hong Kong Monetary Authority, the de facto central bank, has surrendered control of its interest rates to the Fed since 1983 </li></ul><ul><li>That is fine when US and Hong Kong economic cycles are in sync </li></ul><ul><li>Inability to use monetary policies caused the 1997-98 Asian Financial crises </li></ul><ul><li>Dollar depreciation caused last year great financial instability </li></ul><ul><li>Intervention to defend the fixed rate (injection of money and interest rates adjustments) have inevitable knock-on effect on asset prices </li></ul><ul><li>Hong Kong property booms have always been associated with periods of currency weakness – remember 1995, 1982, 1972 – and very rapid monetary growth </li></ul>4 1 2 3
    13. 13. The HK Dollar peg What is the cost of keeping 1 USD = 7.80 HKD? (cnt’d) <ul><li>Currency appreciation </li></ul><ul><li>At the time of the Asian currency crisis, Hong Kong, despite a huge drop in output and prices, not only had to maintain an official exchange rate that had become comparatively overvalued relative to other Asian countries, which saw their currencies plunge, but also had to match its interest rates with the high interest rate levels in the U.S., where the economy was still strong </li></ul><ul><li>Fighting the markets is becoming increasingly expensive </li></ul>4 1 2 3
    14. 14. The HK Dollar peg What is the cost of keeping 1 USD = 7.80 HKD? (cnt’d) <ul><li>Speculators </li></ul><ul><li>Recent rise of the HKD was in part due to speculators betting on a revaluation </li></ul><ul><li>In August 1998, Soros and his flagship Quantum Fund bet heavily that Hong Kong would end up on bended knee, but it was not to be </li></ul><ul><li>The fund mounted a 3-sides assault on the currency, futures and stocks </li></ul><ul><li>Hong Kong intervened in the markets, although there was concern in some quarters that the government had dipped into the Exchange Fund </li></ul><ul><li>Even the Bank of China supported the counterattack on speculators </li></ul><ul><li>“ From what we see now, the HKSAR government chose the right time to intervene. We made a mistake at the time.” </li></ul><ul><li>Asset manager who represented George Soros during the 1997 Asian Currency Crisis </li></ul>4 1 2 3
    15. 15. AGENDA 1 2 3 4 The Hong Kong Dollar Peg Manulife and the Insurance Industry Risks for Manulife Proposed Strategy 4 1 2 3
    16. 16. Manulife Brief Introduction <ul><li>The largest life insurance company in Canada, the second largest in North America and the sixth largest in the world </li></ul><ul><ul><li>with a market capitalization of approximately Cdn$ 53 billion (US$ 52 billion) as of June 30, 2008 </li></ul></ul><ul><ul><li>Funds under management of Cdn$ 400 billion (US$ 393 billion) as at June 30, 2008 </li></ul></ul><ul><li>Approximately 24,000 employees and thousands of distribution partners serving millions of customers in 19 countries and territories worldwide </li></ul>
    17. 17. <ul><li>Ratings </li></ul><ul><ul><li>Financial strength is a key factor in generating new business and expanding distribution relations </li></ul></ul><ul><ul><li>Manulife's Life insurances’ financial strength and claims paying ratings are among the strongest in the industry </li></ul></ul>Manulife Performance <ul><li>Performance </li></ul><ul><ul><li>Comparison between the Total Return for $100 invested in Manulife from Dec1999 to Jun2008 with the Total Return of the S&P/TSX composite Index and the S&P/TSX Composite Financials Index </li></ul></ul>Rating Agency Rating A.M Best A++ (1st of 15 categories) Dominion Bond Rating Service IC-1 (1st of 5 categories) FitchRatings AA+ (2nd of 9 categories) Moody's Aa1 (2nd of 9 categories) Standard and Poor's AAA (1st of 8 categories)
    18. 18. Manulife Profitability 56% 27%
    19. 19. Manulife Revenues
    20. 20. <ul><li>Operates in Asia since 1897, beginning in Hong Kong and the Philippines, expanding into other countries </li></ul><ul><li>Products portfolio: </li></ul><ul><ul><li>Protection products: </li></ul></ul><ul><ul><ul><li>life insurance/ group life and health/ hospital </li></ul></ul></ul><ul><ul><li>Wealth management products: </li></ul></ul><ul><ul><ul><li>Mutual funds, pensions, variable annuities </li></ul></ul></ul><ul><li>Well diversified by product, geography and distribution channel with operations in 10 countries and territories </li></ul>Manulife Manulife in the Asia Pacific Region
    21. 21. <ul><li>Manulife has been conducting business in Hong Kong for more than one hundred years </li></ul><ul><li>Self-sustaining operation centre </li></ul><ul><li>Issues life policies in Hong Kong denominated in HKD </li></ul><ul><li>75% of revenues generated in the region are from HK </li></ul><ul><li>Sales rank: #7 globally </li></ul><ul><li>Exposure to exchange rate changes between the Canadian and Hong Kong Dollars </li></ul>Manulife Manulife in Hong Kong
    22. 22. Manulife Risk Management <ul><li>Enterprise-wide approach to all risk taking and risk management activities globally </li></ul><ul><li>The risk management framework sets out policies and standards of practice related to: </li></ul><ul><ul><li>Risk governance </li></ul></ul><ul><ul><li>Risk identification and monitoring </li></ul></ul><ul><ul><li>Risk measurement </li></ul></ul><ul><ul><li>Risk control and mitigation </li></ul></ul><ul><li>Individual risk management strategies are also in place for each specific key risk within the broad risk categories: </li></ul><ul><ul><li>Strategic, credit, market and liquidity, insurance and operational </li></ul></ul>
    23. 23. <ul><li>To ensure consistency, these strategies incorporate policies and standards of practice that are aligned with those within the enterprise risk management framework, covering: </li></ul><ul><ul><li>Assignment of risk management accountabilities across the organization </li></ul></ul><ul><ul><li>Delegation of authorities related to risk taking activities </li></ul></ul><ul><ul><li>Philosophy related to assuming risks </li></ul></ul><ul><ul><li>Establishment of specific risk limits </li></ul></ul><ul><ul><li>Identification, measurement, monitoring, and reporting of risks </li></ul></ul><ul><ul><li>Activities related to risk control and mitigation </li></ul></ul>Manulife Risk Management (cnt’d)
    24. 24. <ul><li>Risk measures: </li></ul><ul><ul><li>a variety of risk measures </li></ul></ul><ul><ul><li>Range from simple key risk indicators and scenario impact analyses, to deterministic stress testing of earnings value, as well as sophisticated stochastic scenario modeling of economic capital and earnings at risk. </li></ul></ul><ul><li>Risk control: </li></ul><ul><ul><li>Used to mitigate risks within the approved limits </li></ul></ul><ul><ul><li>Controls Includes: policies, procedures, systems and processes </li></ul></ul><ul><li>Risk mitigation: </li></ul><ul><ul><li>Such as product and investment portfolio management, hedging, reinsurance and insurance protection </li></ul></ul><ul><ul><li>Used to ensure the aggregate risk remains within the risk appetite and limits </li></ul></ul>Manulife Risk Management (cnt’d)
    25. 25. <ul><li>Approves and oversees execution of the enterprise risk management framework </li></ul><ul><li>Approves key risk policies and limits </li></ul><ul><li>Establishes risk taking philosophy and risk appetite </li></ul><ul><li>Monitors risk exposures </li></ul><ul><li>Reviews major risk taking activities </li></ul><ul><li>Risk control and mitigation </li></ul><ul><li>Oversees global risk taking activities and risk management </li></ul><ul><li>Risk identification and monitor </li></ul>Manulife Risk Governance Board of Directors Level Audit & Risk Management Committee (ARMC) Conduct Review and Ethics Committee Management Resources and Compensation Committee CEO CFO Chief Risk Officer Executive Risk committee (ERC) Corporate Risk Management (CRM) Product Oversight Committee Credit Committee Global Asset Liability Committee
    26. 26. <ul><li>Asset/Liability Management Processes </li></ul><ul><ul><li>Risk management policies prepared by senior management and approved by the Corporate Asset Liability committee (ALCO) and the Board of Directors </li></ul></ul><ul><ul><li>Comprehensive understanding of how both assets and liabilities behave in different environments as well as the risk/return preferences of the company </li></ul></ul><ul><ul><li>Asset Mix: </li></ul></ul><ul><ul><ul><li>Insurance business: </li></ul></ul></ul><ul><ul><ul><ul><li>Simulation analysis provides input to senior management in setting and approving targets that optimize returns within acceptable risk constraints </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Investment benchmarks and guidelines </li></ul></ul></ul></ul><ul><ul><ul><li>Annuity business: </li></ul></ul></ul><ul><ul><ul><ul><li>Determined based on available investment spreads and liquidity considerations </li></ul></ul></ul></ul><ul><ul><li>Interest Rate Risk Policies </li></ul></ul>Manulife Risk management in Hong Kong
    27. 27. <ul><li>Based in Toronto </li></ul><ul><li>Headed by Felix Chee, executive vice-president and chief investment officer </li></ul><ul><li>Mr. Otsuki headed the Capital Markets group </li></ul><ul><ul><li>Manage short-term investments </li></ul></ul><ul><ul><li>Prepare derivative strategies </li></ul></ul><ul><ul><li>Ensure a consistent stream of earnings </li></ul></ul><ul><ul><li>Tools: foreign exchange contracts, interest rate and cross currency swaps, forward rate agreements and equity fluctuations </li></ul></ul>Manulife The Investment Management Group
    28. 28. AGENDA 1 2 3 4 The Hong Kong Dollar Peg Manulife and the Insurance Industry Risks for Manulife Proposed Strategy 4 1 2 3
    29. 29. HKD Exposure for Manulife Main Risks <ul><li>Foreign Exchange Risk </li></ul><ul><li>Key attribute: Adverse general market movement against your currency </li></ul><ul><li>Safety Measure: Hedge regularly; Keep most of the currency in the domestic market (avoid foreign exchange) </li></ul><ul><li>Interest Rate Risk </li></ul><ul><li>Key attribute: Price or rate changes may adversely affect the return </li></ul><ul><li>Safety Measure: Keep maturities short; Keep portfolio diverse in terms of maturity issuers </li></ul>4 1 2 3
    30. 30. HKD Exposure for Manulife Data <ul><li>Date </li></ul><ul><li>Current date: 16 September 1998 </li></ul><ul><li>HKD/USD </li></ul><ul><li>Current exchange rate: 7.75 HKD/USD </li></ul><ul><li>Value of the portfolio </li></ul><ul><li>Total Value: 1,787,644,582 HKD </li></ul><ul><li>Duration of the portfolio </li></ul><ul><li>Maturity of single bonds approximated their durations </li></ul><ul><li>Maturity: 2.65 </li></ul>4 1 2 3
    31. 31. HKD Exposure for Manulife Assumptions <ul><li>Since October 1997, there has been a significantly wider spread along the whole term interest rate structure much of which is attributable to the “Asian risk premium” (Chart 1) </li></ul><ul><li>Even in the Singaporean flexible exchange rate regime, interbank rates exhibit similar volatility and similar external shock patterns as in Hong Kong (Chart 2) </li></ul><ul><li>Nominal rates in the two cities differed in the past with different inflation rates but recently the nominal rate has tended to converge </li></ul>4 1 2 3 <ul><li>Why we chose 35% bottom (lower bound of the expected drop) </li></ul>
    32. 32. HKD Exposure for Manulife Assumptions <ul><li>We can compare the combined interest rate and exchange rate volatilities in two currencies under different exchange rate regimes applying the Value at Risk concept to two portfolios (e.g. US$10 mn each in 3-month deposits in HKD and in SGD) </li></ul><ul><li>The combined risks of the portfolios are the foreign exchange risk and the interest rate risk </li></ul>4 1 2 3 <ul><li>Why we chose 35% bottom (lower bound of the expected drop) </li></ul>
    33. 33. HKD Exposure for Manulife Assumptions <ul><li>Why we chose 35% bottom (lower bound of the expected drop) </li></ul><ul><li>Even if the combined volatilities between two exchange rates with identical fundamentals should converge over time, the above charts show that combined market volatilities under a fixed exchange rate regime is not always necessarily higher than that under a floating exchange rate regime (1) </li></ul><ul><li>Singapore had a similar product mix and economy as Hong Kong’s so it can be a good reference for the calculation </li></ul><ul><li>Singapore Dollar dropped 20% since June 1997 so this could be our poxy </li></ul><ul><li>Speculators are mounting short positions on the futures and stock markets and HIS </li></ul><ul><li>That would push the devaluation in the short term even lower </li></ul><ul><li>(1) </li></ul>27/10/2008 International Finance 4 1 2 3
    34. 34. HKD Exposure for Manulife Assumptions <ul><li>Why we chose 1.5% increase in interest rates </li></ul><ul><li>While there has been concerns that interest rates can rise to unsustainable levels, given the effectiveness of interest rate arbitrage and the flexibility of the Hong Kong economy, the inflation rate is expected to trend lower through 1998 in line with the slowdown in economic growth </li></ul><ul><li>The decline in inflation and a slowdown in growth would be passed on to a decline in nominal interest rates </li></ul><ul><li>The rise in real US interest rates, the drain of liquidity due to capital outflows from the Asian region , and higher risk premium due to the external shock from the Asian currency turmoil have already resulted in a rise in the level of real interest rates </li></ul>27/10/2008 International Finance 4 1 2 3
    35. 35. HKD Exposure for Manulife Assumptions <ul><li>Why we set the probability of the unpeg at 30% </li></ul><ul><li>HKMA mounted an unprecedented counter-attack against speculators and banks who lent them the money to open the short positions </li></ul><ul><li>The most effective policy instrument under a fixed exchange rate regime is not monetary policy, but fiscal policy </li></ul><ul><li>Hong Kong has ample fiscal reserves and sound fiscal policy (as demonstrated by the fiscal surplus of 5.4% of GDP during 1997/98) </li></ul><ul><li>The 1998/99 Budget announced by the Financial Secretary on 18 February 1998 has shown the way how fiscal probity, together with the robust Linked Exchange Rate system, can deliver monetary and financial stability in Hong Kong </li></ul><ul><li>Rumors want some Chinese Banks are helping HKMA in remaining stable </li></ul>27/10/2008 International Finance 4 1 2 3
    36. 36. HKD Exposure for Manulife Monte Carlo Simulation <ul><li>What it is </li></ul><ul><li>One type of spreadsheet simulation in which randomly values are generated for uncertain variables over and over to simulate a model </li></ul><ul><li>For each uncertain variable in a simulation, you define the possible values with a probability distribution </li></ul><ul><li>How it works </li></ul><ul><li>A simulation calculates numerous scenarios of a model by repeatedly picking values from the probability distribution for the uncertain variables and using those values for the cell </li></ul><ul><li>The forecast results show you not only the different result values for each forecast, but also the probability of obtaining any value </li></ul>4 1 2 3
    37. 37. HKD Exposure for Manulife Calculation methodology - Distributions <ul><li>HKD/USD: Beta </li></ul><ul><li>Distribution that represents the variability over a fixed range or describes empirical data </li></ul><ul><li>Set at minimum of 4.5 HKD/USD with the likeliest value of 5 (around 35% decrease) </li></ul>4 1 2 3
    38. 38. HKD Exposure for Manulife Calculation methodology - Distributions <ul><li>Interest rate: Normal </li></ul><ul><li>Distribution that is symmetrical about the mean and it is more likely to be close to the mean than far away </li></ul><ul><li>Mean set at 1.50% change in interest rates </li></ul>4 1 2 3
    39. 39. HKD Exposure for Manulife Calculation methodology - Distributions <ul><li>Odds of the event: </li></ul><ul><li>YES-NO </li></ul><ul><li>Distribution that describes the number of times an event occurs in a fixed number of trials </li></ul><ul><li>Probability set at 30% of occurrence </li></ul>4 1 2 3
    40. 40. HKD Exposure for Manulife Results <ul><li>Best Fit: BETA Distribution </li></ul><ul><li>We can consider the Mean Forecast Value as the most probable Exposure measure for Manulife: 569,967,485 HKD </li></ul>4 1 2 3
    41. 41. HKD Exposure for Manulife Results <ul><li>Best cut-off </li></ul><ul><li>After 3 years the portfolio exposure will capture already more than 70% of the total, therefore we can concentrate on those securities </li></ul>4 1 2 3
    42. 42. AGENDA 1 2 3 4 The Hong Kong Dollar Peg Manulife and the Insurance Industry Risks for Manulife Proposed Strategy 4 1 2 3
    43. 43. Hedge Methodology Intro 4 1 2 3 <ul><li>Steps in hedging: </li></ul><ul><li>Identify the cash market risk exposure that management wants to reduce </li></ul><ul><li>Determine the appropriate position to mitigate the risk </li></ul><ul><li>Select the appropriate financial instruments </li></ul><ul><li>Determine the number of those financial instruments to trade </li></ul><ul><li>Implement the hedge </li></ul><ul><li>Determine when to get out of the hedge position </li></ul><ul><li>Verify that the financial instruments traded meet the regulatory requirements and conform the internal risk management policies </li></ul>
    44. 44. Hedge Methodology Intro 4 1 2 3 <ul><li>Hedge based on: </li></ul><ul><li>Two parameters to be accounted: Value and Duration of the portfolio </li></ul><ul><li>In deciding the hedge entity for each bond we can apply the weight of that bond on the entire portfolio </li></ul><ul><li>In deciding the maturity/tenor/expiring date of the hedge we match this period in time with the duration of the high-grade bond to be hedged </li></ul><ul><li>Other considerations </li></ul><ul><li>Regulatory barriers (banks are restricted to using certain financial instruments for hedging purposes) </li></ul><ul><li>Short/Medium-Term </li></ul><ul><li>Hang Seng Index 40% lower than its high; 40% lower if HKD unpegged </li></ul><ul><li>Real Estate properties expected to go down 40% in value if HKD unpegged </li></ul>
    45. 45. Hedge Methodology Intro 4 1 2 3 <ul><li>Types of hedges: </li></ul><ul><li>Short Hedge: sell futures on securities similar to those evidencing the cash market risk </li></ul><ul><li>Cross Hedge: because it is extremely difficult to obtain a perfect hedge hence, a participant can use futures based on one security that differs from the security being hedged in the cash market </li></ul><ul><li>Microhedge: hedging of a transaction associated with a specific asset </li></ul><ul><li>Macrohedge: involves taking future positions to reduce the aggregate portfolio risk (measured in the case of interest rates risk through the sensitivity of earnings or EVE) </li></ul><ul><li>Underlined assets </li></ul><ul><li>HSI, equities; Eurodollars, HKD or USD; HIBOR </li></ul>
    46. 46. Hedge Methodology Microhedge with futures 4 1 2 3 <ul><li>Determine the risk exposure: </li></ul><ul><li>The objective is to know in what rate environment the company loses </li></ul><ul><li>Comparison of rate forecast and the losses if these rates materialize </li></ul><ul><li>The key decision involves determining how much risk is acceptable </li></ul><ul><li>Determine the number of contracts: </li></ul><ul><li>NF = b x [(A x Mc) / (F x Mf)] </li></ul><ul><li>A: dollar value of cash flow to be hedged </li></ul><ul><li>F: face value of a contract </li></ul><ul><li>Mc: maturity o duration of anticipated cash asset or liability </li></ul><ul><li>Mf: maturity or duration of futures </li></ul><ul><li>b: E[rate movement on cash instrument] / E[rate movement on futures] </li></ul>
    47. 47. Hedge Methodology Macrohedge with futures 4 1 2 3 <ul><li>Determine the aggregate risk exposure: </li></ul><ul><li>Using GAP is possible to assess the dollar magnitude of rate-sensitive assets minus that of liabilities over different time intervals </li></ul><ul><li>If positive there is an asset sensitivity </li></ul><ul><li>If we want to immunize the portfolio, DGAP should be set to 0 </li></ul><ul><li>Determine the number of contracts: </li></ul><ul><li> EVE/Market Value of Assets = - DGAP x  y / (1 + y) </li></ul><ul><li>DGAP: duration gap [WDA – (WDL x D/E)] </li></ul><ul><li>y: average interest rate for the portfolio </li></ul><ul><li>EVE: economic value of equity </li></ul><ul><li>We can calculate the size of the position through solving an equality with the mv of futures and the mv of assets and liabilities each multiplied by their durations and divided by their interest rates </li></ul>
    48. 48. Hedge Methodology Other instruments 4 1 2 3 <ul><li>Forward Rate Agreements: </li></ul><ul><li>Forward based on interest rates in which 2 parties agree to a notional principal that serves as reference in determining the cash flow </li></ul><ul><li>The buyer (Manulife) pays a fixed-rate coupon payment and receives a floating rate payment against the notional principal at some date </li></ul><ul><li>Being credit instruments, FRAs carry the risk of default of the counterparty </li></ul><ul><li>Interest Rate Swaps </li></ul><ul><li>Agreement between 2 parties to exchange a series of cash flows based on a notional principal amount </li></ul><ul><li>Again, the buyer (Manulife) pays fixed and receives floating-rate payments </li></ul><ul><li>Maturities from 6 months to 30 years </li></ul><ul><li>Transactions executed through a dealer that manifested all the risks for each party </li></ul>
    49. 49. Hedge Methodology Summary 4 1 2 3   Position Objective Financial Futures FRAs & Basic Swaps Profit if rates rise Sell Pay Fixed, receive floating Profit if rates fall Buy Pay floating, receive fixed   Position Objective Equities/HSI Futures Profit if market rise Buy Profit if market fall Sell   Position Objective Foreign Currency (USD) Forward & Basic Swap Profit if peg remains Sell Profit if peg is broken Buy
    50. 50. Hedge Methodology Other strategies 4 1 2 3 <ul><li>Caps and floors: </li></ul><ul><li>Options on interest rates </li></ul><ul><li>An interest rate cap is an agreement between two counterparties that limits the buyer’s (Manulife) interest rate exposure to a maximum rate (it corresponds to buying a series of consecutive calls on a floating-rate index) </li></ul><ul><li>Considering the economic conditions this choice could present a high price (premium) at which the option trades </li></ul><ul><li>A collar (simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount) would provide income that reduces the cost of the cap </li></ul><ul><li>Real Estate </li></ul><ul><li>In the worst case scenario in which property prices fall, this could be a potential long-term (around 10 years) investment </li></ul>
    51. 51. <ul><li>Thank you! </li></ul>Q&A
    52. 52. The HK Dollar peg Facts and Figures of Hong Kong’s economy 4 1 2 3
    53. 53. The HK Dollar peg Facts and Figures of Hong Kong’s economy 4 1 2 3 <ul><li>A report issued Tuesday by Medley Global Advisors, a boutique research firm founded by Richard Medley, former chief political strategist to George Soros, said Hong Kong had been lobbying Beijing to alter the peg system, but the suggestion was rejected by the central government </li></ul>
    54. 54. <ul><li>The following charts show the composition of the Company’s internal risk-based capital by broad risk category and product line. </li></ul>1 2 3 1 2 3
    55. 55. Risk management (6) <ul><li>Foreign currency Risk: </li></ul><ul><ul><li>Key risk factors: </li></ul></ul><ul><ul><ul><li>A substantial portion of the company’s global business is denominated in currencies other than Canadian dollars, mainly U.S. dollars, Hong Kong dollars and Japanese yen. </li></ul></ul></ul><ul><ul><ul><li>If the Canadian dollar strengthened relative to non-Canadian currencies, the translated value of reported earnings from these non-Canadian denominated businesses would decrease and the translated value of our reported share-holders’ equity would decline </li></ul></ul></ul><ul><ul><li>Management Strategy: </li></ul></ul><ul><ul><ul><li>A policy of matching the currency of assets with the currency of the liabilities. </li></ul></ul></ul><ul><ul><ul><li>It support to mitigate economic exposure to currency exchange rate changes. </li></ul></ul></ul><ul><ul><li>The following table shows the impact on shareholder’s equity and net income of a 1% change in the Canadian dollar relative to non-Canadian currencies </li></ul></ul>