Joint Regional Seminar 2016 Risk Analysis of Equity-linked Products - PowerPoint PPT Presentation

Joint Regional Seminar 2016 Risk Analysis of Equity-linked Products 1

Equity-linked products 2

Structured products • Market-linked investment (Investment-linked products) – Credit-linked notes (CLN) – Interest rate-linked notes – Equity-linked note (ELN) – FX and commodity-linked notes – Equity-indexed annuities (EIA) – Variable annuities (VA) • Guaranteed benefits • Embedded options – Exotic option features 3

EIA vs VA • Equity-indexed annuities (EIA) – Like a call option • Variable annuities (VA) Fixed Annuity Indexed Annuity EIA guarantee (fixed at 4%) (capped at 8%) – Like a put option (floor rate: 0%)  PTP indexing payoff  Periodic interest credit $100,000 $100,000 between $0 and $8,000 VA guarantee VA guarantee $8,000 $8,000 $5,000 • $4,000 $4,000 $4,000 $4,000 $4,000 $4,000 $4,000 Guaranteed minimum payoff $2,000 maturity benefit (GMMB) 0 1 2 3 4 5 6 0 1 2 3 4 5 6 Index: • Guaranteed minimum death 100 104 105 108 109 102 99 index benefit (GMDB) • Guaranteed minimum accumulation benefit (GMAB) index 4

Historical development of investment-linked insurance • UK – Unit-linked policy (1957) • US – Variable life (mid-1970s) – Variable universal life (1986) • HK – Investment-linked long-term insurance products (late 1980s) – [OCI] As of 2013, office premiums amounted to • HKD 69,895.8 million in-force business (29.0%) • HKD 19,115.7 million new business (21.5%) (of total office premiums of individual life business) 5

• • • Airbag Daily accrual Early call Special Features • Airbag • Daily accrual • Early call Acknowledgment: 6 Investor Education Centre

Examples • Target redemption note Autocall Structured Deposit – Example (2009): Target Redemption Note – Example (2004): • Autocall structured deposit • • Selling point 7.5% USD Target Redemption Index Linked Deposit •  Profit from China’s equity market recovery Selling point • Accumulators •  Enjoy potentially higher returns with Index Linked Deposit 7-year contract • • Principal received upon maturity only. 100% principal protection plus 7.5% guaranteed coupon return over a • Variable life insurance • If it is redeemed or sold prior to maturity, the maximum of 5-year investment period • 1st year annual coupon is guaranteed at 3.5% (  ), payable semi- investor may face fees. • Equity indexed annuity • annually. hard to sell in the secondary markets. • • Coupon payment: 5% guaranteed (  ) at the end of the first year The remaining coupon rate of 1% will be based on the LIBOR movement. The inverse floater formula is Max{7% – 2 × (6-month LIBOR), 0} • However, the total coupon received cannot shoot beyond the target • If the worst off stock in the basket > 10%, it is “auto - called” and will pay. accumulation rate of 7.5%. If the coupon payment accrued during the • deposit period is less than the target rate, then the remaining amount will Otherwise, the contract continue to the next year until the 7th in which no be paid at maturity. Otherwise, it will be terminated earlier. coupon would be paid except for the guaranteed 5%. 7

Risk involved in equity-linked investments • Limited market making • Not principal protected • Different from investing • Limited potential gain in the reference asset(s) • Credit risk of the issuer • Conflicts of interest • No collateral Acknowledgment: 8 Investor Education Centre

Practical issues in modeling • Model financial market events Deterministic or random • Model policyholder events Based on various contingencies 9

Data issues • Data source: Actuarial organizations such as Society of Actuaries Canadian Institute of Actuaries Bloomberg Yahoo! Finance • Data should be readily available and clean • Good data enhances credibility of modeling results 10

Level of data • Country or region index: Standard & Poor 500, Hang Seng Index • Sub-index: Hang Seng Property Index • Individual stocks • Which one should be used? • What is the composition of your portfolio? 11

Length of historical data • Usually starts from initial public offering • Maybe too short for long term estimations • Proxies can be prior company; parent, sister or competitor in same industry • Maybe too long and include extreme events • Beware of change in name or type of shares 12

Frequency of data • Annual • Monthly • Daily 13

Issues with daily equity data • Missing data • Typos in data • Data for holidays (calendar days vs trading days) • Typhoons (exchange closure) • Trading suspension 14

Timing of daily equity data • Last or mid-day • Time difference for data from different exchanges • Closing: median of last 5 trades • Adjusted closing 15

Adjustment of equity data • Merger or split • Currency • Dividend: cash or stock • Price vs return 16

Size of data files • Can be very large • Difficulty in storing and transferring data 17

Modeling approaches • Deterministic vs stochastic • Choice of model 18

Deterministic approach • Factors: – Interest rate – Dividend rate – Economic growth rate • Relationship of equity returns with these factors • Scenarios to be tested 19

Stochastic approach • Number of simulation paths • Does it involve nested stochastic? • Is the range of results reasonable? • Is it necessary to truncate the extreme values? 20

Choice of model • Requirements for a model to work • Will the model produce odd patterns of results? • Is it appropriate for the product under study? • Compare modeling results with theoretical values • Monitor differences between actual and modeled values 21

Types of models • Cascade model: Wilkie model • Log-normal model • Draw down model • Regime switching model • Stochastic volatility model 22

Wilkie model 23

Log-normal model y t = μ + σε t with ε t ~ N(0, 1) or y it = μ i + σ i ε it with ε it ~ N(0, 1) and E( ε it ε jt ) = ρ ij where i ≠ j 24

Draw down model y t = κ + β d t + σε t with ε t ~ N(0, 1) and d t = Min(0, d t -1 + y t ) 25

Regime switching model In regime 1, y t = μ 1 + σ 1 ε t with ε t ~ N(0, 1) In regime 2, y t = μ 2 + σ 2 ε t with ε t ~ N(0, 1) Pr(Going to regime 2 | Regime 1) = p 12 Pr(Going to regime 1 | Regime 2) = p 21 26

Stochastic volatility model 27

Goodness of fit measures • Log-likelihood • Akaike information criteria AIC = - 2*log-likelihood + 2*npar • Schwartz Bayes criteria SBC = - 2*log-likelihood + npar*log(nobs) • Quantile-Quantile (QQ) plot of residuals 28

Calibration of equity returns • Criteria on percentiles for different time horizons • How stringent are the calibration criteria? • Is correlation among returns reflected? • Can some parameters be negative? • When will the scenarios have to be re-calibrated? 29

Simplified model • For quick turnaround • Must provide reasonably good fit to full model • Can be used to predict outcome of full model run 30

Risk measures • Standard deviation • Value at risk • Conditional tail expectation • Opportunity cost compared to another investment 31

Q & A 32