ALM question

[Olivia]

Any one here can give me some advice on how to calculate market value of liability cash flows that used in Duration/Convexity stuff. Do you use any specific software?

I work for a small company who is a little behind in ALM area, and I don't have any prior experience too except those lists from Course 6.

[chapman_kolmogorov]

Find the Market Value of the Capital, then subtract it from the Market Value of the Assets.

[Olivia]

Originally Posted by chapman_kolmogorov

Find the Market Value of the Capital, then subtract it from the Market Value of the Assets.

Thanks for reply. Maybe this is too silly, but what is Capital? I'm working on a line of existing business, and want to compare duration of asset and liability. But I'm not very confident on the way our software calculates MV of liability. Basically it uses a discount rate equal to short-term Treasury + OAS. And the OAS is derived from asset portfolio.

[Sherwin]

You could make cash flow testing(CFT) for the liability product and use the cash flows resulting from the CFT model to match A/L duration.

[Jack]

Originally Posted by Sherwin

You could make cash flow testing(CFT) for the liability product and use the cash flows resulting from the CFT model to match A/L duration.

No you can't do that.

You need to generate arbitrage free yield curves in order to get market values. Regarding software consider that the model has two parts. First is the model office that models decrements, credited interest etc. Any actuarial model will do. Next is the economic model. As previously mentioned you'll need a yield curve generator that is suited for the purpose. If your software doesn't actually calculate the market value you could easily write a piece of code to do that.


Partner with your investment department, they should be able to help. They're probably already expert in this type of analysis and frankly they're usually much smarter than actuaries.

[Happy Extinction]

Smarter than actuaries? That's unpossible!!

[Olivia]

Originally Posted by Jack

No you can't do that.

You need to generate arbitrage free yield curves in order to get market values. Regarding software consider that the model has two parts. First is the model office that models decrements, credited interest etc. Any actuarial model will do. Next is the economic model. As previously mentioned you'll need a yield curve generator that is suited for the purpose. If your software doesn't actually calculate the market value you could easily write a piece of code to do that.


Partner with your investment department, they should be able to help. They're probably already expert in this type of analysis and frankly they're usually much smarter than actuaries.

I agree with Jack that we can't use CFT. Because for the calculation of Duration you need to shift yield curve up and down. So basically you will need to calculate MV under 3 sets of interest scenairos, that's not something CFT can give.

We do have a interest generator here. And according to my knowledge from course 6, the best way to calculate liability MV would be use a discount rate = spot rate + OAS. Say if we can get spot rate curve from the current yield curve, how to decide the OAS? I feel Investments won't be helpful in this part.

[chapman_kolmogorov]

The treasury plus OAS approach can't be correct. The OAS is relevant to the assets but not the liabilities. In order to use that approach you need the required spread on liabilities.

Getting back to your question: what is the market value of capital?

It is the present value of distributable earnings discounted at the cost of capital. The cost of capital is a weighted average required returns of capital sources (e.g. debt and equity). The required returns are composed of a risk premium and a risk free rate and should vary with the short rate over the life of the projection.

[Olivia]

Originally Posted by chapman_kolmogorov

The treasury plus OAS approach can't be correct. The OAS is relevant to the assets but not the liabilities. In order to use that approach you need the required spread on liabilities.

Getting back to your question: what is the market value of capital?

It is the present value of distributable earnings discounted at the cost of capital. The cost of capital is a weighted average required returns of capital sources (e.g. debt and equity). The required returns are composed of a risk premium and a risk free rate and should vary with the short rate over the life of the projection.

Chapman, do you have any paper/book handy explains this approach? I may need to do more reading to be able to understand this.

Thanks!

[sunman]

I work in ALM. You need a Monte Carlo term structure model to calculate the OAS (unless you're just using a simple binomial, I guess). Also, why are you using:

(short-term Treasury) + OAS

and not using the whole Treasury curve? It is much better to use the whole Treasury yield curve, right?

How are you calculating your OAS?