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

10th November 2008

The Art of Risk Management

Hedging un(der)rewarded Risk

2


Contents

Liability Driven Investing (LDI) 3

Implementation of LDI Hedging 5

Swap Considerations 6

How to use Asset Managers 9

Redington Implementation Framework 11

Lehman Brothers – A Case Study 22

LDI 2008 and Beyond 27

Conclusions 32


LDI – Liability Driven Investing

3

Transaction: 2004-2006. Sponsor top-up + interest rate and inflation swaps.

The First Holistic LDI Transaction Transaction: Dec 2003. Long-dated interest rate and inflation swaps.

Transaction: 2001 to 2004. Equity to bond switch + inflation swaps.

Transaction: Sep 2005. Exchange equities and fixed income instruments for swaps and equity options

2002: Adaption of FRS17 (UK)

Explosion of asset managers offering LDI solutions, e.g. pooled/segregated funds.

LDI strategies take off. In the first half of 2008 LDI assets had increased 27%.

2001 2002 2003 2004 2005 2006 2007 2008 2009

Conversion of Swap/Gilt

Yield


LDI Evolution

Inversion of Swap/Gilt

Yield

?

Pensions Act & IAS 19 Amended

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Implementation of LDI Hedging

Swap Considerations

5


Swaps – The Practicalities

6

Main Considerations

ISDA and CSA Documentation • Master agreement, schedule, confirmation.

Trading / Best Execution • Consistent pricing.

Counterparty Risk

Cash Management and Collateralization • Frequency of collateral calls, quality of collateral, haircut.

Valuation / Accounting / Reporting

Costs • Bid/offer spread, opportunity cost, slippage, advisory, legal, custodian.

Compliance

Market Challenges


Evolution 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 / strategy

Historical Nominal Swap Rates

Historical Inflation (RPI) Swap Rates

Source: Bloomberg / Redington

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, set threshold (requires ISDA and CSA in place with each counterparty).

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Counterparty Analysis

5 Year Senior Debt Credit Default Swap (CDS) Levels



How to use Asset Managers

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10

The Evolution of LDI Implementation

2007 2008

Services Asset Manager* Redington + ?

Portfolio construction

ISDA negotiations

Daily pricing grids

Counterparty selection

Dealing band analysis Sometimes

Execution of swap programme Asset Manager

Execution reports Sometimes

Ongoing portfolio monitoring/rebalancing

Libor generating assets Asset Manager

2009

*Some items will have been done in conjunction with scheme’s investment advisor


Evolution of LDI Implementation

Redington Implementation Framework

Implementation of LDI Hedging Programme

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Step 8: Solution Monitoring

Step 7: Execution monitoring

Step 6: Accessing market “axes” and opportunistic hedging

Step 5: Appropriate Dealing costs

Step 4: Optimal transaction size(s)

Step 3: Optimal timing of execution

Step 2: Framework to minimise market impact

Step 1: Establish a Working Party to make tactical execution decisions based on current market levels

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Implementation Framework - Eight Steps


Liability Cash Flows

• An important part of our analysis is the reverse engineering of the pension scheme’s actuarially approved cash flows (opposite).

• We re-run the raw data with a wide range of mortality, wage, inflation and interest rate assumptions to ensure that the proposed swap portfolio 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 and

are for illustration purposes only.

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• Swap prices are received from the trading desk on a daily basis;

• Real time trading spreads for both interest rate and inflation swaps are established;

• Dealing costs across different trade sizes and maturities are covered;

• A comprehensive picture of genuine axes across the yield curve is built;

• Investment bank works with trustees and Redington to ensure we can source swaps around points of super liquidity, allowing access to large PV01 at attractive dealing spreads.

Pre-trade Execution Process – Daily Pricing Grids


Step 1: Framework to Minimise Market Impact

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Indicative pricing for IRS swaps

Tradeweb

Bloomberg

SuperDerivatives

31-Oct-08 PV01 £'000s

IRS 50 100 250 500 750 1000

2y 0.380 0.38 1.00 1.50 1.75 2.00

5y 0.380 0.38 1.00 1.50 1.75 2.00

10y 0.380 0.38 1.00 1.50 1.75 2.00

12y 0.380 0.38 1.00 1.50 1.75 2.00

15y 0.380 0.38 1.00 1.50 1.75 2.00

20y 0.380 0.38 1.00 1.50 1.75 2.00

25y 0.380 0.38 1.00 1.50 1.75 2.00

30y 0.380 0.38 1.00 1.50 1.75 2.00

50y 0.380 0.38 1.00 1.50 1.75 2.00

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RPI Sample Swap Pricing Grids – increased dealing spreads 31-Oct-07 PV01 £'000s

RPI 50 100 250 500 750 1000

2y 0.500 1.000 1.500 2.250 2.750 3.500

5y 0.500 1.000 1.500 2.250 2.750 3.500

10y 0.500 1.000 1.500 2.250 2.750 3.500

12y 0.500 1.000 1.500 2.250 2.750 3.500

15y 0.500 1.000 1.500 2.250 2.750 3.500

20y 0.500 1.000 1.500 2.250 2.750 3.500

25y 0.500 1.000 1.500 2.250 2.750 3.500

30y 0.500 1.000 1.500 2.250 2.750 3.500

50y 0.500 1.000 1.500 2.250 2.750 3.500

31-Oct-08 PV01 £'000s

RPI 50 100 250 500 750 1000

2y 25.000 25.000 30.000 35.000 40.000 40.000

5y 15.000 16.000 17.000 18.000 19.000 20.000

10y 15.000 16.000 17.000 18.000 19.000 20.000

12y 15.000 16.000 17.000 18.000 19.000 20.000

15y 15.000 16.000 17.000 18.000 19.000 20.000

20y 15.000 16.000 17.000 18.000 19.000 20.000

25y 10.000 11.000 12.000 13.000 14.000 15.000

30y 1.000 1.500 2.000 2.500 3.000 4.000

50y 0.500 1.000 1.500 2.500 3.500 4.500

• Over the last few months, significant pricing differentials have developed among market participants.

• 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.



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Comparison Inflation Dealing Spreads



Progress to Fully Hedged

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• Redington and the investment bank will advise where it may be advantageous to pay a tighter spread for a proposed swap given the absolute level of yields available, as well as tactical considerations.

• Investment banks shall meet exacting pricing and execution standards in order to remain a preferred counterparty.

• Redington will advise whether: • The Present Value implied by the transaction on offer is

appropriate/within a pre-defined trading band; • The proposed spread charge is appropriate to the size of the

transaction 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 to execute.

• To date we have helped clients achieve substantial savings in hedging PV01 as a result of:

• Using our relationships with banks’ trading desks; • Helping clients improve their governance structure.

Appropriate Dealing Costs

Accessing market “axes” and opportunistic hedging

Following the Market

• There is no single optimal transaction size – it will depend on market conditions;

• Continuously survey views and sentiment of interest and inflation traders;

• Track macroeconomic factors affecting liquidity (supply and demand).


Step 4-6: Optimal Transaction Size, Dealing Costs, Market “Axes”


Step 4-6: Optimal Transaction Size, Dealing Costs, Market “Axes”

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Executing Optimal Transactions

0

100

200

300

400

500

600

700

800

900

1,000

01/10/2008 05/10/2008 09/10/2008 13/10/2008 17/10/2008 21/10/2008 25/10/2008 29/10/2008

PV

01

(£

Th

ou

san

ds)

Date

Actual Cumulative PV01 Phase 1 Standard Pace

Execution Monitoring

On the proposed day(s) for executing, the Investment Manager approaches the investment bank for information on whether the pricing is consistently competitive in the desired maturities and on the combined switch package. A complete monitoring process should carry the following features:

During Trading – Trader should find the real market mid price, guaranteeing that other banks are not pushing market mid because they know of the trade (information leakage).

Real Time Pricing – After every trade, verify the transaction report and check pricing obtained against independent pricing sources i.e. Bloomberg and TradeNet.

Independent Review – At the end of the switching programme, it is recommended to carry through an independent review of the asset manager’s performance in order to ensure that the required level of governance has been reached.

Risk Management – Ongoing risk management will require constant access to holdings, positions, regular reporting, collateral management and an alert system.

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Step 7: Execution Monitoring

* 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 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’s performance. 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 the solutions implemented. It works with clients and asset managers to adjust the hedging programme on a yearly basis (or as required).

• Operational Monitoring – Daily reconciliations between swap counterparty and custodian, an independent valuation 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 Monitoring

Daily monitoring

• Independent Valuation Check

• Verification (Comparison with appropriate

market)

• Counterparty Credit Monitoring Tool

Ongoing management

• Monthly Reporting

• Scenario Analysis

• Rebalance Analysis

Example of Ongoing Monitoring and Management


Step 8: Solution Monitoring

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Lehman Brothers

A Case Study

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What happens when a swap counterparty vanishes?

Mark-to-Market (MTM) of

Outstanding Swaps

• Determine exact moment of bankruptcy:

• Value outstanding collateral;

• Obtain 5 bank Quotes to value all outstanding swap positions;

• Or determine “Loss”.

Determine net payment 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 releases collateral to counterparty.

New Swaps/Hedges

•Execute new replacement swaps at current market levels; or

•Buy bonds (Government/inflation) wait for more favourable market conditions.

•Do nothing - Run market risk.

Swap Collateral

Investment Banks

• Provided clients with a poll of swap

prices to help determine close out levels

with Lehman.

• Made markets on replacement trades

for clients.

• Lehman was not a major LDI

counterparty but some estimates

suggest they had over £3m PV01 of

RPI exposure, and much more in

nominals.

• On Monday, 15 Sep ‘08, an estimated

50% to 60% of this was traded, which

pushed swap break-evens 10bps

higher.


Implication of Lehman’s Failure – Case Study

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What are the key risks / costs associated with replacing a swap?

• Potential shortfall between value of collateral and MTM of swap value;

• Bid / offer spread charged on replacement transaction;

• Open market risk from time of bankruptcy until new hedge implemented;

• Availability of replacement swap given illiquid market conditions.

Breakevens implied by swaps were

sharply higher in the long end with 30yrs

trading at the psychologically important

4.00% level (up 11bps on the day).

Replacement of Lehman Risk (est.) in the Market (change in RPI Swap Curve)




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CDO crisis

Northern Rock nationalised

Bear Sterns bought out by JP Morgan

Lehman Brothers file for

bankruptcy. Fed leave short term rates unchanged

Overnight GBP Libor



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Managing Counterparty Risk

1. 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 cash amount 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 inflation sensitivity as previously;

• This frees up cash to invest in assets to generate a return above LIBOR, and reduces credit exposure to swap counterparty.

3. Novate or assign swaps to new swap counterparties

• Pension fund completely replaces hedging bank counterparty in swap agreement. New swap counterparty executes "back to back" swap with old swap counterparty.


Counterparty Risk

LDI 2008 and Beyond

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Synthetic (Unfunded) Assets

Equity Futures

iTraxx/CDS

Nominal Swaps

RPI Swaps

Cash (Funded) Assets

Equities

Corporate Bonds

UK Gilts

Index Linked Gilts

Tactical Switch

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What 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 the strategic LDI target;

• Tactical switches in one component are limited by the manager’s ability to free up cash whilst maintaining the risk exposure in remaining components.


LDI 2008 and Beyond

Longevity Swaps

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What is driving the current environment

Prior to this point swaps were preferable to gilts; since then the situation has reversed.

• “Flight to quality” has meant a rush to buy short dated gilts, not long dated linkers (short swap spreads are still very positive, over 100bps);

• Lack of inflation supply in

swap market, coupled with continued high demand from pension funds, has caused swap inflation to become expensive relative to gilt inflation;

• Expectation of increased gilt

issuance due to increasing fiscal pressures has led to general cheapening of gilts;

• General lack of funding in the financial system has meant reduced appetite for holding bonds that need to be financed.

• “Real” 30 year swap spread is the difference in yield between the 30 year real rate zero coupon swap and the 2037 index-linked gilt;

• Although the extreme anomaly observed at the long end of the real yield curves has begun to reverse, it remains desirable to take advantage of the phenomenon whereby long-term gilt real yields exceed those of swaps.


LDI 2008 and Beyond

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Generating LIBOR + Returns


LDI 2008 and Beyond

UK Government long dated

Linker

Pension Scheme

Bank

Inflation-linked coupon + Redemption

Inflation-linked coupon + Redemption

Initial Principal Libor + xx bps + Principal

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Current Opportunities

Hedged / Partial Hedged Schemes

• Buy nominal / index-linked gilts

• Switch from swaps into

nominal / index-linked gilts for: • Yield pickup; • Reduction in

counterparty risk.

• Retain swaps and enter asset swap to lock in ‘Libor plus’ returns

Unhedged Schemes • Buy nominal / index-linked gilts

(to roughly match the duration and characteristic of scheme liabilities);

• Actively monitor market and portfolio.

• The swap spread reached a low of over minus 120 basis points but has rebounded as some investors have increased their allocation to index-linked gilts.


LDI 2008 and Beyond


Conclusions

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LDI 2009 and Beyond


What Lies Ahead?

• More dynamic approach;

• Unconstrained liability-matching tool kit;

• Exploitation of relative value opportunities;

• Continuance of hedging against interest rate and inflation risks;

• Regular portfolio monitoring becoming essential.

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Hedging Risk – VaR Road Map

Contacts

Dawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415 [email protected] Robert Gardner | Partner Direct: +44 (0) 207 250 3416 [email protected] Redington Partners LLP 13 -15 Mallow Street London EC1Y 8RD Telephone: +44 (0) 207 250 3331

www.redingtonpartners.com THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT

Contacts

Disclaimer

Disclaimer 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 discussion purposes 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 the parameters 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 appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein 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 is indicative 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 executed transactions 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' actuarial advisors. 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 that estimation. 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. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such 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 as accurate.

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

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