introduction to derivative products and dfa
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Introduction to Derivative Products and DFA. Lawrence A. Berger, Ph.D. Swiss Re New Markets Daniel B. Isaac, FCAS Falcon Asset Management Division of Swiss Re DFA Seminar: Managing Risk in a Portfolio Context. What Is A Derivative?. - PowerPoint PPT PresentationTRANSCRIPT
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Introduction toDerivative Products
and DFA • Lawrence A. Berger, Ph.D.
– Swiss Re New Markets• Daniel B. Isaac, FCAS
– Falcon Asset Management Division of Swiss Re
• DFA Seminar: Managing Risk in a Portfolio Context
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What Is A Derivative?
• Financial instrument whose value is derived from the performance of an “underlying asset”
• Refer to “cash price,” or “spot price” of the underlying
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What Is An Underlying Asset?
• Can be anything
• Performance should be quantifiable
• Some examples are:
– Interest Rates
– Equities
– Foreign Exchange Rates
– Commodities
– Indices
– Loss Ratios
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How Is A Derivative Created?
• Derivative product is a contractual agreement between two parties to either:
– exchange cash flows, or
– have one party assume a risk of the other party for a price
• Derivative product uses the “underlying asset” as a basis for the exchange
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Options
• An Option Contract gives the owner the right, but not the obligation, to buy or sell an underlying asset at an exercise price on or before an agreed date
– Call = Right to buy at X
– Put = Right to sell at X
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Options
V
P
V
P
Buy A PutV
P
V
P
Buy A Call
Sell A Put Sell A Call
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Options
• Options have a Time Value and an Intrinsic Value
Call option value
Time value
P
V
Intrinsic value
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Options Summary
• Intrinsic Value
– Call = Max(P-X,0)
– Put = Max(X-P,0)
• Option Premium = Intrinsic value plus time value
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Pricing an Option
• Calculations dependent on several factors
– Spot price of underlying asset
– Strike price - price at which option allows owner to purchase or sell underlying asset
– Interest rates
– Volatility - measure of frequency and relative size of changes in price of underlying asset
– Time to expiration
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Volatility
Probability
Price of UnderlyingAsset
StrikePrice
FwdPrice
Low Vol. Asset
High Vol. Asset
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Interest Rate Cap
• An agreement where the seller agrees to pay the buyer, in return for a premium, the difference between the reference rate and an agreed strike rate should the reference rate rise above the strike
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Cap Payoff Profile
Cap
Interest Rate
Gain/Loss
Strike
Premium
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Cap = Hedge High Rates
• An interest rate cap is essentially an insurance policy against interest rates rising
• A cap buyer is protected against rates rising beyond the strike
• A cap seller receives a fee and gives up return if rates rise beyond strike
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Double Trigger Cover
• Reinsured pays a premium to purchase cover if two different risk events occur
– The correlations between the two events are low or non-existent
– Lack of correlation allows for lower premiums
• Example: interest rate option with catastrophe trigger
– Option protects against losses on portfolio of fixed income instruments
– Option is exercisable only after Cat event
Interest Rates
CatastrophicEvent
No
Yes
IncreaseDecrease
No Cover Sell Assets, Pay Losses
No Cover, No Losses
CoveredCollect Reinsurance
No Cover, No Losses
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Double Trigger CoverEquity Protection
Stock Market
CatastrophicEvent
No
Yes
DeclineIncrease
No Cover Sell Assets, Pay Losses
No Cover, No Losses
CoveredCollect Reinsurance
No Cover, No Losses
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Falcon’s Integrated Risk Management Process
Evaluation and Simulation of Economy(s)and Capital Market(s)
Evaluation and Simulation of Balance Sheet Items
Surplus Optimization(Efficient Frontier)
Sensitivity Testing
Strategic Business Decisions
Step 1
Step 2
Step 3
Step 4
Step 5
Business mix Reinsurance strategy Mergers, Acquisitions and
Divestitures
Analysis of Results:- Decomposition of Risk- Downside Analysis- RBC- Solvency
Investment Strategy Derivatives Capital Allocation/Structure
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Primarily short-tailed property business
Large portion (~50%) of book is CAT exposed
As a result of large liability risk, very conservative investment strategy: 20% cash, 80% bonds
PCIC Company Profile
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Aggregate CAT cover: 300 x 100 calendar year loss ratio from CATs
Price: 30% of subject earned premium
Placement: 50%
No reinstatements or rebates
Traditional Cover
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Aggregate CAT cover: 300 x 100 calendar year loss ratio from CATs
Recovery reduced based on S&P 500 return: Below 0%: No reduction Above 20%: Zero recovery Between 0% and 20%: Pro-rata reduction
Price: 12.5% of subject earned premium
Placement: 100%
No reinstatements or rebates
Dual Trigger CoverIncome Smoothing
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Shareholder's Equity Efficient Frontier3-Year Time Horizon
Current Reinsurance
700.0
720.0
740.0
760.0
780.0
800.0
820.0
840.0
860.0
880.0
140.0 160.0 180.0 200.0 220.0 240.0 260.0 280.0
Standard Deviation of Shareholder's Equity ($mm)
Sh
are
ho
lde
r's
Eq
uit
y (
$m
m)
Current
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Shareholder's Equity Efficient Frontier3-Year Time Horizon
Current Reinsurance
Traditional Cover
700.0
720.0
740.0
760.0
780.0
800.0
820.0
840.0
860.0
880.0
110.0 130.0 150.0 170.0 190.0 210.0 230.0 250.0 270.0 290.0
Standard Deviation of Shareholder's Equity ($mm)
Sh
are
ho
lde
r's
Eq
uit
y (
$m
m)
Current Traditional Cover Efficient Frontier
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Shareholder's Equity Efficient Frontier3-Year Time Horizon
Traditional Cover
Current Reinsurance
Dual Cover
700.0
720.0
740.0
760.0
780.0
800.0
820.0
840.0
860.0
880.0
110.0 130.0 150.0 170.0 190.0 210.0 230.0 250.0 270.0 290.0
Standard Deviation of Shareholder's Equity ($mm)
Sh
are
ho
lde
r's
Eq
uit
y (
$m
m)
Traditional Cover Current Dual Cover Efficient Frontier
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Similar book to PCIC
More heavily reinsured
More aggressive investment strategy: 50% stocks, 50% short-term bonds
Myth Company Profile
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Aggregate CAT cover: 300 x 100 calendar year loss ratio from CATs
Price: 25% of subject earned premium
Placement: 50%
No reinstatements or rebates
Traditional Cover
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Notional Amount: 75% of earned premium
Trigger: Calendar year loss ratio of at least 75%
Recovery based on S&P 500 return: Below -20%: 100% of notional Above 0%: Zero recovery Between 0% and -20%: Pro-rata reduction
Price: 3% of earned premium
Placement: 100%
No reinstatements or rebates
Dual Trigger CoverCatastrophe Protection
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400,000
450,000
500,000
550,000
600,000
650,000
700,000
750,000
800,000
850,000
Current Reinsurance Traditional Cover Dual Cover
1% to 5% 5% to 25% 25% to 50% 50% to 75%
End of Year: 3 out of 3Shareholder Equity