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M A N A G I N G P E N S I O N S C H E M E R I S K U S I N G D E R I V A T I V E S

M A N A G I N G P E N S I O N S C H E M E R I S K U S I N G D E R I V A T I V E S. Mark Crawley and Chris Watts. 1. 2. Building Blocks. 3. Liability Driven Investment (LDI). 4. Pensions restructuring using derivatives. 5.

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M A N A G I N G P E N S I O N S C H E M E R I S K U S I N G D E R I V A T I V E S

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  1. M A N A G I N G P E N S I O N S C H E M E R I S K U S I N G D E R I V A T I V E S Mark Crawley and Chris Watts

  2. 1 2 Building Blocks 3 Liability Driven Investment (LDI) 4 Pensions restructuring using derivatives 5 EFFICIENTLIABILITYMANAGEMENTUSINGDERIVATIVES 6 7

  3. Industry practitioners recognise the advantages of derivatives over cash assets INTRODUCTION FTfm, Switching to bonds is not the answer Economist, When the spinning stops • “Derivatives are good” : 419 hits • “Derivatives are evil” : 19 hits

  4. 5 5 5 5 0 0 0 0 -5 -5 -5 -5 -10 -10 -10 -10 4 4 4 4 4 4 2 2 2 2 2 2 3 3 3 3 3 3 5 5 5 5 5 5 1 1 1 1 1 1 Inflation-linked instruments Interest rate swap: zero coupon and regular coupon 10 Receive notional x (real coupon) 10 Receive notional x (1+ real coupon)^5 Pay notional x (Libor +/- spread) Pay notional x (Libor +/- spread) Inflation-linked derivative structures: zero coupon and regular coupon INFLATION-LINKEDDERIVATIVES Receive notional x (real coupon + annual inflation) 10 10 Receive notional x% change in RPI from 1-5 Pay notional x (1+rate)^5 Pay notional x (Libor +/- spread)

  5. The Swap market is significantly more liquid than the Gilt market • Swap transactions are OTC • More liquid than the Gilt market • Outstanding Nominal = 10 trillion pounds • Collateralization virtually eliminates the counterparty risk Sterling Swaps vs Gilts; £BN INTERESTRATESWAPS Source: BIS Source : BIS / DMO

  6. Greater use of derivativesWhy use derivatives vs. traditional securities? • Ability to unbundle risks (Duration, convexity, FX, credit, equity risks etc) • Greater flexibility • Ability to replicate liability more closely • Ability to dynamically amend risk profile • Alpha generation (short positions) INTRODUCTION

  7. Liability Driven Investment (LDI) 1 2 Building Blocks 3 4 Pensions restructuring using derivatives 5 EFFICIENTLIABILITYMANAGEMENTUSINGDERIVATIVES 6 7

  8. What is Liability Driven Investment (LDI)? Changes in investment approaches over time Swaps overlay to remove duration mismatch New strategies ‘Leveraged’ swaps Duration matching bond strategy Traditional Equity/ Bond Strategy • Ease of liability matching • Higher returns • Friction costs LIABILITYDRIVENINVESTMENT

  9. LDI in context Change of efficient frontier LDI solution Excess return over gilts Starting point: “Traditional” strategy - equities plus bonds LIABILITYDRIVENINVESTMENT Immunising gilt/swap portfolio Asset-Liability Risk

  10. Schematic overview of a example hedging structure Pension Scheme owns the Trust Trust Pension Scheme Consultants LIABILITYDRIVENINVESTMENT Portfolio Management Agreement Asset Manager

  11. Schematic overview of a example hedging structure Pension Scheme owns the Trust Trust Pension Scheme Consultants Collateral for the Trust LIABILITYDRIVENINVESTMENT Government Bond Fund Portfolio Management Agreement Asset Manager Fund Management

  12. Schematic overview of a example hedging structure One way Credit Support Annex Pension Scheme owns the Trust Zero Coupon Swaps JPM Trust Pension Scheme Consultants Collateral for the Trust Asset Swaps LIABILITYDRIVENINVESTMENT Government Bond Fund Portfolio Management Agreement Asset Manager Fund Management

  13. Schematic overview of a example hedging structure One way Credit Support Annex Pension Scheme owns the Trust Investment Bank faces multiple dealers Zero Coupon Swaps JPM Trust Pension Scheme Interest Rate Delta Hedges Dealer 1 Dealer 2 Consultants Dealer 3 Collateral for the Trust Asset Swaps LIABILITYDRIVENINVESTMENT Portfolio Management Agreement Government Bond Fund Interest Rate Delta Auction Asset Manager Fund Management

  14. LDI case study: Projected funding levels 200% Yield up 3% • Traditional Equity Strategy • Bond matching strategy • LDI strategy 180% Funding Level 160% 140% 120% 100% LIABILITYDRIVENINVESTMENT 80% 60% Yield down 3% 40% 0 1 2 3 4 5 6 7 8 9 10 Years

  15. LDI case study: Historical funding levels LIABILITYDRIVENINVESTMENT

  16. Liability Driven Investment (LDI) 1 2 Building Blocks 3 4 Pensions restructuring using derivatives 5 EFFICIENTLIABILITYMANAGEMENTUSINGDERIVATIVES 6 7

  17. Strategy for pensions restructuring Liability Strategies Asset Strategies …. such as SPI LDI ALM • Commodity Underlyings • Traditional funded strategies • Property underlyings • Long-Short Credit Strategies PENSIONSRESTRUCTURINGUSINGDERIVATIVES • Long Short Equity Strategy • CDOs • ARIA II - Synthetic CDO • Equity derivatives • Equity Volatility Strategy • Global Asset Rotator • Hedge Funds • Enhanced money market fund • Credit Linked Investment Portfolio • FX Strategy Alpha and Beta generation strategies

  18. M A N A G I N G P E N S I O N S C H E M E R I S K U S I N G D E R I V A T I V E S E F F I C I E N T   L I A B I L I T Y   M A N A G E M E N T   U S I N G   D E R I V A T I V E S Mark Crawley mark.a.crawley@jpmchase.com Tel: 020 7779 3155 Chris Watts christopher.s.watts@jpmorgan.com Tel: 020 7779 3155

  19. EFFICIENTLIABILITYMANAGEMENTUSINGDERIVATIVES This presentation was prepared exclusively for the benefit and internal use of ACA in order to indicate, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure to any other party. This presentation is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this presentation nor any of its contents may be used for any other purpose without the prior written consent of JPMorgan. The information in this presentation is based upon management forecasts and reflects prevailing conditions and our views as of this date, all of which are subject to change. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of ACAor which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of ACA. JPMorgan is a marketing name for investment banking businesses of J.P. Morgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loan arranging, financial advisory and other investment banking activities are performed by J.P. Morgan Securities Inc. and its securities affiliates, and lending, derivatives and other commercial banking activities are performed by JPMorgan Chase Bank and its banking affiliates. JPMorgan deal team members may be employees of any of the foregoing entities.

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