Actuarial Investments

1
Actuarial Investments

• Shane Whelan
• L527

2
Description of Key Markets

• - THE BOND MARKET
• II of II

3
Sundry Points on Bond Markets

• Strips common now in most developed bond
  markets,
• e.g. in UK conventional gilt market, on
  conventional and IL (US) Treasuries. In most
  sovereign bond markets since 1999.
• Repos sell and buy-back agreements to raise
  money on secure terms.
• See Money Market as well
• Stock-lending.
• Enabling some to short a stock sell what they
  do not own.

4
Index-Linked Bonds

• Introduced 1981 in UK, now in many countries (US
  since 1997).
• Payments coupon redemption proceeds escalate
  in line with consumer price inflation, lagged a
  no. of months.
• Typically, smaller issue sizes than conventional
  gilts hence lower marketability.
• Quote real yield
• a fall in real yield leads to an increase in
  real price.

5
Real Yield on Gov. Guaranteed Index-linked Bonds,
2002
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Yield Curves

• Yield curve a graph of the (best-fit) GRY on
  gilts against unexpired term.
• Often separate one drawn for high, medium, and
  low coupon bonds FTSE Actuaries Government
  Securities (UK) yield indices.
• Other methods to overcome problem of different
  coupon levels are generally too elaborate, e.g.,
  the yield surface.
• Strip curve (or zero coupon curve or spot curve)
  yield curve when all gilts are zero coupon.
• Also known as the term structure of interest
  rates
• This is key for theoretical considerations

7
Yield Curves

• Par yield curve the coupon that would be
  required by the market for a gilt issued at par
  for the given term. The axes are coupon value
  (y-axis) against term to redemption (x-axis).
• Used by issuer (in Ireland the NTMA but elsewhere
  generally central banks)
• Important to understand when issuance is at
  significant levels.

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Theories of Shape of the Yield Curve

• Expectations Theory yield curve gives the
  markets expectations for the future course of
  short-term interest rates.
• A (crude) application of the REH
• Implies that if yield curve changes then this
  must mean that investors views of future
  interest rates have changed
• In particular, their expectations of inflation
  affect both interest rate level and trends hence
  yield curve level and shape

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Theories of Shape of the Yield Curve

• Liquidity Preference Theory investors as a
  class prefer liquid assets to illiquid ones.
  Longer dated stocks are less liquid than shorter
  dated stocks hence yields should be higher on
  higher dated stocks.
• A fair point made, but overdone.

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Theories of Shape of the Yield Curve

• Market Segmentation or preferred habitat theory
  yields at each term to redemption are determined
  by supply and demand from investors with
  (nominal) liabilities of that term.
• Different investors have different needs
• Banks at short end
• Life offices and pensions at long end
• Is there a natural hump in UK gilt curve?
• Price is a function of supply demand

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Combining the theories

• Majority of investors want positive real return
  hence demand
• Overall level of curve depends on inflation
  outlook (expectations theory)
• Want compensation for uncertainty with an
  inflation risk premium which is upward sloping
  with term (by liquidity preference theory)
• Within this overall shape, near independent
  movements in the different maturity ranges
  reflecting supply and demand conditions in the
  different habitats (Market Segmentation)

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The Real Yield Curve

• Make a wild guess on its definition!
• What theories would you propose for the shape of
  the real yield curve?

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Relationship between Real Nominal Yields

• Nominal Yield Real Yield Expected
  future inflation inflation risk premium
• Hence difference between nominal and real yield
  curve gives markets expectation for inflation
  plus the inflation risk premium.
• Inflation risk premium can be positive or
  negative.

14
Switching between conventional IL

• Conventional bonds will outperform index-linkers
  if expectations of future inflation fall and vice
  versa. Hence your portfolio split between these
  categories depends on how your inflation
  expectations differ from the markets.
• So we can indirectly trade inflation
  expectations.
• IN TRADING THE GAME IS THAT ONE
• Must anticipate the markets anticipation of the
  event