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The Art of Risk Management- Hedging Un(der)rewarded Risk


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The Art of Risk Management- Hedging Un(der)rewarded Risk

  1. 1. 10th November 2008The Art of Risk ManagementHedging un(der)rewarded Risk
  2. 2. 2Hedging un(der)rewarded RiskContentsLiability Driven Investing (LDI) 3Implementation of LDI Hedging 5Swap Considerations 6How to use Asset Managers 9Redington Implementation Framework 11Lehman Brothers – A Case Study 22LDI 2008 and Beyond 27Conclusions 32
  3. 3. Hedging un(der)rewarded RiskLDI – Liability Driven Investing3
  4. 4. Transaction: 2004-2006.Sponsor top-up +interest rate andinflation swaps.The First HolisticLDI TransactionTransaction: Dec 2003.Long-dated interestrate and inflationswaps.Transaction: 2001 to 2004.Equity to bond switch +inflation swaps.Transaction: Sep 2005.Exchange equities andfixed incomeinstruments for swapsand equity options2002: Adaptionof FRS17 (UK)Explosion of asset managersoffering LDI solutions, e.g.pooled/segregated funds.LDI strategies take off. In the first half of2008 LDI assets had increased 27%.2001 2002 2003 2004 2005 2006 2007 2008 2009Conversionof Swap/GiltYieldHedging un(der)rewarded RiskLDI EvolutionInversion ofSwap/GiltYield?Pensions Act & IAS19 Amended
  5. 5. Implementation of LDI HedgingSwap Considerations5
  6. 6. Hedging un(der)rewarded RiskSwaps – The Practicalities6Main ConsiderationsISDA and CSA Documentation• Master agreement, schedule, confirmation.Trading / Best Execution• Consistent pricing.Counterparty RiskCash Management and Collateralization• Frequency of collateral calls, quality of collateral, haircut.Valuation / Accounting / ReportingCosts• Bid/offer spread, opportunity cost, slippage, advisory, legal, custodian.Compliance
  7. 7. Market ChallengesHedging un(der)rewarded RiskEvolution of LDI Implementation• Reduced liquidity• Inability to deal across the curve;• Banks reluctant to transact large volumes.• Counterparty failure• Bear Stearns, Lehman Brothers.• Wider spreads• Need for new execution methods / strategyHistorical Nominal Swap RatesHistorical Inflation (RPI) Swap RatesSource: Bloomberg / Redington
  8. 8. Managing Counterparty Risks• Only transact with high-quality counterparties, i.e. those with strong long-term credit ratings.• Reduce time between mark-to-market, i.e., arrange weekly or daily collateral support agreement, setthreshold (requires ISDA and CSA in place with each counterparty).8Hedging un(der)rewarded RiskCounterparty Analysis5 Year Senior Debt Credit Default Swap (CDS) LevelsSource: Bloomberg / Redington
  9. 9. Implementation of LDI HedgingHow to use Asset Managers9
  10. 10. 10The Evolution of LDI Implementation2007 2008Services Asset Manager* Redington + ?Portfolio constructionISDA negotiationsDaily pricing gridsCounterparty selectionDealing band analysis SometimesExecution of swap programme Asset ManagerExecution reports SometimesOngoing portfoliomonitoring/rebalancingLibor generating assets Asset Manager2009*Some items will have been done in conjunction with scheme’s investment advisorHedging un(der)rewarded RiskEvolution of LDI Implementation
  11. 11. Redington Implementation FrameworkImplementation of LDI Hedging Programme11
  12. 12. Step 8: Solution MonitoringStep 7: Execution monitoringStep 6: Accessing market “axes” and opportunistic hedgingStep 5: Appropriate Dealing costsStep 4: Optimal transaction size(s)Step 3: Optimal timing of executionStep 2: Framework to minimise market impactStep 1: Establish a Working Party to make tactical execution decisions based on current market levels12Hedging un(der)rewarded RiskImplementation Framework - Eight Steps
  13. 13. Hedging un(der)rewarded RiskLiability Cash Flows• An important part of our analysis isthe reverse engineering of thepension scheme’s actuariallyapproved cash flows (opposite).• We re-run the raw data with a widerange of mortality, wage, inflationand interest rate assumptions toensure that the proposed swapportfolio is fully optimised.Detailed Cash Flow and (PV01) Modelling* The intention of this material is simply to illustrate the type of analysis that can and should, in our view, be carried out in order to help formulate a clear strategy for funding,risk management and asset allocation. You should not rely upon any calculations or numbers as correct. They are obtained from limited publicly available information andare for illustration purposes only.13
  14. 14. • Swap prices are received from the trading desk on adaily basis;• Real time trading spreads for both interest rate andinflation swaps are established;• Dealing costs across different trade sizes and maturitiesare covered;• A comprehensive picture of genuine axes across theyield curve is built;• Investment bank works with trustees and Redington toensure we can source swaps around points of superliquidity, allowing access to large PV01 at attractivedealing spreads.Pre-trade Execution Process – Daily Pricing GridsHedging un(der)rewarded RiskStep 1: Framework to Minimise Market Impact14Indicative pricing for IRS swapsTradewebBloombergSuperDerivatives31-Oct-08 PV01 £000sIRS 50 100 250 500 750 10002y 0.380 0.38 1.00 1.50 1.75 2.005y 0.380 0.38 1.00 1.50 1.75 2.0010y 0.380 0.38 1.00 1.50 1.75 2.0012y 0.380 0.38 1.00 1.50 1.75 2.0015y 0.380 0.38 1.00 1.50 1.75 2.0020y 0.380 0.38 1.00 1.50 1.75 2.0025y 0.380 0.38 1.00 1.50 1.75 2.0030y 0.380 0.38 1.00 1.50 1.75 2.0050y 0.380 0.38 1.00 1.50 1.75 2.00
  15. 15. 15RPI Sample Swap Pricing Grids – increased dealing spreads31-Oct-07 PV01 £000sRPI 50 100 250 500 750 10002y 0.500 1.000 1.500 2.250 2.750 3.5005y 0.500 1.000 1.500 2.250 2.750 3.50010y 0.500 1.000 1.500 2.250 2.750 3.50012y 0.500 1.000 1.500 2.250 2.750 3.50015y 0.500 1.000 1.500 2.250 2.750 3.50020y 0.500 1.000 1.500 2.250 2.750 3.50025y 0.500 1.000 1.500 2.250 2.750 3.50030y 0.500 1.000 1.500 2.250 2.750 3.50050y 0.500 1.000 1.500 2.250 2.750 3.50031-Oct-08 PV01 £000sRPI 50 100 250 500 750 10002y 25.000 25.000 30.000 35.000 40.000 40.0005y 15.000 16.000 17.000 18.000 19.000 20.00010y 15.000 16.000 17.000 18.000 19.000 20.00012y 15.000 16.000 17.000 18.000 19.000 20.00015y 15.000 16.000 17.000 18.000 19.000 20.00020y 15.000 16.000 17.000 18.000 19.000 20.00025y 10.000 11.000 12.000 13.000 14.000 15.00030y 1.000 1.500 2.000 2.500 3.000 4.00050y 0.500 1.000 1.500 2.500 3.500 4.500• Over the last few months, significant pricing differentials have developed among marketparticipants.• Some banks are unwilling to openly quote in large volumes at the short end of the curve.• For longer maturities, market axes continue to keep spreads tight.Hedging un(der)rewarded RiskStep 1: Framework to Minimise Market Impact
  16. 16. 16Comparison Inflation Dealing SpreadsHedging un(der)rewarded RiskStep 1: Framework to Minimise Market Impact
  17. 17. Progress to Fully Hedged17• Redington and the investment bank will advise where it may be advantageousto pay a tighter spread for a proposed swap given the absolute level of yieldsavailable, as well as tactical considerations.• Investment banks shall meet exacting pricing and execution standards in orderto remain a preferred counterparty.• Redington will advise whether:• The Present Value implied by the transaction on offer isappropriate/within a pre-defined trading band;• The proposed spread charge is appropriate to the size of thetransaction and the absolute level of the market;• There is a stable market;• There are any other factors to consider.• Redington will make a recommendation as to whether is appropriate toexecute.• To date we have helped clients achieve substantial savings in hedgingPV01 as a result of:• Using our relationships with banks’ trading desks;• Helping clients improve their governance structure.Appropriate Dealing CostsAccessing market “axes” and opportunistic hedgingFollowing the Market• There is no single optimal transaction size – it will depend on marketconditions;• Continuously survey views and sentiment of interest and inflation traders;• Track macroeconomic factors affecting liquidity (supply and demand).Hedging un(der)rewarded RiskStep 4-6: Optimal Transaction Size, Dealing Costs, Market “Axes”
  18. 18. Hedging un(der)rewarded RiskStep 4-6: Optimal Transaction Size, Dealing Costs, Market “Axes”18Executing Optimal Transactions01002003004005006007008009001,00001/10/2008 05/10/2008 09/10/2008 13/10/2008 17/10/2008 21/10/2008 25/10/2008 29/10/2008PV01(£Thousands)DateActual Cumulative PV01 Phase 1 Standard Pace
  19. 19. Execution MonitoringOn the proposed day(s) for executing, the InvestmentManager approaches the investment bank for information onwhether the pricing is consistently competitive in the desiredmaturities and on the combined switch package. A completemonitoring process should carry the following features:During Trading – Trader should find the real market midprice, guaranteeing that other banks are not pushing marketmid because they know of the trade (information leakage).Real Time Pricing – After every trade, verify the transactionreport and check pricing obtained against independent pricingsources i.e. Bloomberg and TradeNet.Independent Review – At the end of the switchingprogramme, it is recommended to carry through anindependent review of the asset manager’s performance inorder to ensure that the required level of governance has beenreached.Risk Management – Ongoing risk management will requireconstant access to holdings, positions, regular reporting,collateral management and an alert system.19Hedging un(der)rewarded RiskStep 7: Execution Monitoring
  20. 20. * The intention of this material is simply to illustrate the type of analysis that can and should, in our view, be carried out in order to help formulate a clear strategy for funding, risk managementand asset allocation. You should not rely upon any calculations or numbers as correct. They are obtained from limited publicly available information and are for illustration purposes only.• Once a solution is in place, monitoring is key to track the evolution of the pension fund and the solution’sperformance. The pension fund should be well informed so that it may adjust its position if necessary.• Redington is in the unique position that it can deliver ongoing analysis of both the pension fund and thesolutions implemented. It works with clients and asset managers to adjust the hedging programme on ayearly basis (or as required).• Operational Monitoring – Daily reconciliations between swap counterparty and custodian, an independentvaluation agent can also be involved.• Compliance Reporting – Independent compliance reports to the Plan on a quarterly basis on key findings.Compliance reporter will work closely with the Internal Audit Department to ensure portfolio managers’continued compliance with client investment guidelines, in management, operations and legal teams.Solution MonitoringDaily monitoring• Independent Valuation Check• Verification (Comparison with appropriatemarket)• Counterparty Credit Monitoring ToolOngoing management• Monthly Reporting• Scenario Analysis• Rebalance AnalysisExample of Ongoing Monitoring and ManagementHedging un(der)rewarded RiskStep 8: Solution Monitoring20
  21. 21. Lehman BrothersA Case Study21
  22. 22. 22What happens when a swap counterparty vanishes?Mark-to-Market(MTM) ofOutstandingSwaps• Determine exact moment of bankruptcy:• Value outstanding collateral;• Obtain 5 bank Quotes to value all outstanding swap positions;• Or determine “Loss”.Determine netpayment flows• Net all outstanding swap contracts with bankrupt counterparty.•If net payments owed to pension fund, collateral claimed.•If collateral insufficient, shortfall is unsecured claim in bankruptcy.•If net payments owed to counterparty, pension fund releasescollateral to counterparty.NewSwaps/Hedges•Execute new replacement swaps at current market levels; or•Buy bonds (Government/inflation) wait for more favourable marketconditions.•Do nothing - Run market risk.Swap CollateralInvestment Banks• Provided clients with a poll of swapprices to help determine close out levelswith Lehman.• Made markets on replacement tradesfor clients.• Lehman was not a major LDIcounterparty but some estimatessuggest they had over £3m PV01 ofRPI exposure, and much more innominals.• On Monday, 15 Sep ‘08, an estimated50% to 60% of this was traded, whichpushed swap break-evens 10bpshigher.Hedging un(der)rewarded RiskImplication of Lehman’s Failure – Case Study
  23. 23. 23What are the key risks / costs associated with replacing a swap?• Potential shortfallbetween value ofcollateral and MTM ofswap value;• Bid / offer spreadcharged on replacementtransaction;• Open market risk fromtime of bankruptcy untilnew hedgeimplemented;• Availability ofreplacement swap givenilliquid marketconditions.Breakevens implied by swaps weresharply higher in the long end with 30yrstrading at the psychologically important4.00% level (up 11bps on the day).Replacement of Lehman Risk (est.) in the Market (change in RPI Swap Curve)Source: Bloomberg / RedingtonHedging un(der)rewarded RiskImplication of Lehman’s Failure – Case Study
  24. 24. 24Source: Bloomberg / RedingtonCDO crisisNorthern RocknationalisedBear Sterns boughtout by JP MorganLehman Brothersfile forbankruptcy. Fedleave short termrates unchangedOvernight GBP LiborHedging un(der)rewarded RiskImplication of Lehman’s Failure – Case Study
  25. 25. 25Managing Counterparty Risk1. Minimise exposure through tightening CSA conditions• Credit risk can be reduced by:• Reducing the time between collateral calls;• Limiting the types of securities that can be posted as collateral to cash and government bonds;• Reducing minimum collateral thresholds to zero.2. Re-coupon swap transactions to current mid-market value• Swap transaction terms should be regularly “updated” such that the hedging bank pays an upfront cashamount to the pension plan, thereby reducing the prevailing mark-to-market value to (or close to) zero, i.e.,it settles up its account;• For this to work, swaps should be re-couponed to have broadly the same interest rate and inflationsensitivity as previously;• This frees up cash to invest in assets to generate a return above LIBOR, and reduces credit exposure to swapcounterparty.3. Novate or assign swaps to new swap counterparties• Pension fund completely replaces hedging bank counterparty in swap agreement. New swap counterpartyexecutes "back to back" swap with old swap counterparty.Hedging un(der)rewarded RiskCounterparty Risk
  26. 26. LDI 2008 and Beyond26
  27. 27. Synthetic (Unfunded) AssetsEquity FuturesiTraxx/CDSNominal SwapsRPI SwapsCash (Funded) AssetsEquitiesCorporate BondsUK GiltsIndex Linked GiltsTacticalSwitch27What Lies Ahead? - Dynamic Active LDI Strategy• Implementing an LDI strategy is not a one-off decision;• As markets move there is relative value between cash and synthetic assets;• A pension scheme can profit from this without losing the hedging or return properties of thestrategic LDI target;• Tactical switches in one component are limited by the manager’s ability to free up cash whilstmaintaining the risk exposure in remaining components.Hedging un(der)rewarded RiskLDI 2008 and BeyondLongevity Swaps
  28. 28. 28What is driving the current environmentPrior to this point swapswere preferable to gilts;since then the situationhas reversed.• “Flight to quality” has meanta rush to buy short datedgilts, not long dated linkers(short swap spreads are stillvery positive, over 100bps);• Lack of inflation supply inswap market, coupled withcontinued high demand frompension funds, has causedswap inflation to becomeexpensive relative to giltinflation;• Expectation of increased giltissuance due to increasingfiscal pressures has led togeneral cheapening of gilts;• General lack of funding in thefinancial system has meantreduced appetite for holdingbonds that need to befinanced.• “Real” 30 year swap spread is the difference in yield between the 30 year real rate zerocoupon swap and the 2037 index-linked gilt;• Although the extreme anomaly observed at the long end of the real yield curves has begunto reverse, it remains desirable to take advantage of the phenomenon whereby long-termgilt real yields exceed those of swaps.Hedging un(der)rewarded RiskLDI 2008 and Beyond
  29. 29. 29Generating LIBOR + ReturnsHedging un(der)rewarded RiskLDI 2008 and BeyondUKGovernmentlong datedLinkerPensionSchemeBankInflation-linked coupon +RedemptionInflation-linked coupon +RedemptionInitial Principal Libor + xx bps + Principal
  30. 30. 30Current OpportunitiesHedged / Partial HedgedSchemes• Buy nominal / index-linked gilts• Switch from swaps intonominal / index-linked gilts for:• Yield pickup;• Reduction incounterparty risk.• Retain swaps and enter assetswap to lock in ‘Libor plus’returnsUnhedged Schemes• Buy nominal / index-linked gilts(to roughly match the durationand characteristic of schemeliabilities);• Actively monitor market andportfolio.• The swap spread reached a low of over minus 120 basis points but has rebounded as someinvestors have increased their allocation to index-linked gilts.Hedging un(der)rewarded RiskLDI 2008 and Beyond
  31. 31. Implementation of LDI HedgingConclusions31
  32. 32. 32LDI 2009 and BeyondHedging un(der)rewarded RiskWhat Lies Ahead?• More dynamic approach;• Unconstrained liability-matching tool kit;• Exploitation of relativevalue opportunities;• Continuance of hedgingagainst interest rate andinflation risks;• Regular portfoliomonitoring becomingessential.
  33. 33. 33Hedging un(der)rewarded RiskHedging Risk – VaR Road Map
  34. 34. ContactsDawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415dawid@redingtonpartners.comRobert Gardner | Partner Direct: +44 (0) 207 250 3416robert.gardner@redingtonpartners.comRedington Partners LLP13 -15 Mallow Street London EC1Y 8RDTelephone: +44 (0) 207 250 3331www.redingtonpartners.comTHE DESTINATION FOR ASSET & LIABILITY MANAGEMENTContactsDisclaimerDisclaimer For professional investors only. Not suitable for private customers.The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussionpurposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that theparameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appearabove are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressedherein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message isindicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executedtransactions should be treated as preliminary and subject to further due diligence .Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees actuarialadvisors. Redington Partners will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in thatestimation. Additionally, the client recognizes that Redington Partners does not owe any party a duty of care in this respect.Redington Partners are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. Thisinformation is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers howsuch particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon asaccurate.34