Derivatives Covering the Risk

Transcription

1 2008 ANNUAL MEETING AND EDUCATION CONFERENCE American College of Investment Counsel New York, NY Derivatives Covering the Risk 2:45 p.m. - 4:00 p.m. October 23, 2008 MODERATOR: James M. Cain Sutherland Asbill & Brennan LLP PANELISTS: Brett Pacific Sun Capital Advisers LLC Brenda J. Page The Hartford Financial Services Group, Inc. Malcolm G. Pittman John Hancock Financial Services, Inc.

2 Derivatives 201 American College Of Investment Counsel 2008 Annual Meeting and Education Conference October 23-24, 2008 Brett Pacific Senior Managing Director Derivatives and Quantitative Strategies SLPC /08 Exp. 12/08 Derivatives Overview Categories: Over-the-counter (OTC): Derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. May require ISDA agreement. Exchange Traded: Derivative products that are traded via specialized derivatives exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. Usage: Hedging Derivatives are used to reduce risk that is inherent to a firm s line of business (e.g. issuing policies). Replication Derivatives are used to replicate the basic risk-and-return profile of a cashbased investment (e.g. buying a stock). 2

3 What is Hedging? Quantifying and managing specific market risks Typically achieved by entering into offsetting hedging instruments that mitigate existing risk exposure Transacting with derivative instruments that mirror embedded options built into our products (maturity/death benefit, return of premium, rate guarantee, etc.) 3 Types of Hedging Strategies Static Hedge: The purchase of option contracts that replicate the embedded option risk profile. Dynamic Hedge: The continuous purchase and sale of liquid instruments to replicate the embedded option risk profile. Hybrid: A combination of Static and Dynamic strategies 4

4 Measuring Risk Risk of different guarantees in the products sold: Changing underlying fund/index prices Changing interest rates Fund/Index price volatility Treat embedded optionality built into products as if they were separate, distinguishable options Once the optionality has been separated, analysis of Greeks can be done to quantify risk exposures Greeks analysis represents option sensitivity to various market (risk) exposures (e.g. delta, gamma, rho, vega) 5 Types of Instruments - Equity Derivatives Equity Index Futures: Cost effective market exposure No upfront cost Example: S&P 500, EuroStoxx 50, Nikkei 225 Equity Swaps: Exposure similar to a series of equity futures No upfront cost Two legged transaction Company receives return of Equity Index Company pays 3m LIBOR + spread Equity Index Options: Option buyer has the right but not the obligation to buy the underlying equity index at a predetermined price Reduce nonlinear equity exposure Reduce Vega and Gamma risk Vega Risk: Gain/Loss due to 1% change in implied volatility Gamma Risk: Change in Delta due to change in price of equity index 6

5 Types of Instruments - Interest Rate Derivatives Interest Rate Swaps: Cost effective way of gaining duration exposure Most swaps are LIBOR based No upfront cost Standard swap is a two legged transaction Interest Rate Swaptions/Floors: Swaption buyer has the right but not the obligation to step into an interest rate swap Reduce nonlinear interest rate exposure Hedge risk profile of guarantee embedded in Annuities Reduce Vega and Convexity risk Vega Risk: Gain/Loss due to 1% change in implied volatility Convexity Risk: Change in Duration due to change in interest rates Interest Rate Futures: Cost effective duration exposure to interest rates/bond market No upfront cost Eurodollar and Bond futures 7 Types of Instruments - Currency Derivatives Currency Forwards: An agreement to exchange two currencies at a future date Used to match future cash flows in a foreign currency Usually short dated transaction e.g months Currency Swaps: Interest rate swap involving 2 different currencies Similar to a series of currency forwards 8

6 Examples of Derivative Strategies Equity Derivative Example Product: GMDB (Guaranteed Min Death Benefit) on VA Risk: Product guarantees return of principal on mutual funds. If stock market goes down, firm needs to pay out a death benefit that could be higher than the account value. Derivatives Used to Hedge: Static: Buy put options on indexes that are highly correlated to underlying risk. Dynamic: Sell basket of futures that are highly correlated to underlying risk Equity Risk Profile of VA S&P 500 Data for Illustrative Purposes Only 10

7 Fixed Income Derivative Example Product: Fixed Annuity Risk: Interest rates decrease below Minimum Rate Guarantee Derivatives Used to Hedge: Static: Buy receiver swaptions or interest rate floors Dynamic: Receive fixed on interest rate swap Risk: Disintermediation Policy Holders will leave as rates rise Derivatives Used to Hedge: Static: Buy payer swaptions or interest rate caps Dynamic: Pay fixed on interest rate swap Change in Value Risk Profile Basis Point Shift Data for Illustrative Purposes Only 11 Currency Derivative Example Product: Universal Life Product issued in Philippines Bond Dealer Risk: Product issued in PHP. Long dated PHP denominated assets not available. USD assets purchased to back liability. USD Upfront Premium Insurance Company PHP Fixed Rate USD Coupon Return of USD Principal USD Fixed Rate PHP Premium Policy Holder Derivatives Used to Hedge : Enter currency swap to pay USD and receive PHP PHP Upfront USD Upfront PHP at Maturity USD at Maturity Derivative Dealer 12

8 Replication Examples Synthetic Convertible Bond Portfolio Investment Rationale Provide asymmetrical return (limiting downside risk; participating when the market rallies) Investment Strategy Investment in equity options is limited to the amount of accrued interest so principal is always protected Gains on the options are captured and reinvested into bonds to lock-in higher protection levels The process of buying options on a regular basis diversifies the option portfolio with respect to term, strike, and initial cost Instruments Bonds managed to Index Equity options on equity Index 14

9 Appendix Delta The change in the value of an option for each dollar change in the market price of the underlying asset. For example, a put option with a delta of 0.50 means a half dollar rise in option premium for every dollar that the underlying asset goes down. Most identifiable and easily hedged risk parameter of all the Greeks Gamma Second order Greek that measures the rate of change in delta per unit change in the price of the underlying security. For example, a put option with a gamma of 0.10 means a 1/10 th rise (fall) in delta for every dollar that the underlying asset goes up (down). Particularly useful in determining rebalancing costs of dynamic hedge (futures) Gamma has most effect (at its highest) when options are at-themoney (ATM) 16

10 Rho Option value s sensitivity to interest rate shifts For example, a put option with a rho of -5.0 means a gain of $5 in option premium for 100bps shift down in interest rates. The impact of Rho increases with the increase expiry of the option. (e.g. embedded option in ten year product) Vega The change in the option's price for a 1% change in volatility (as measured by standard deviation σ) For example, a put option with a vega of 5.0 means a gain of $5 in option premium for 1% increase in volatility Vega has its greatest impact with longer-dated optionality. Because of the longer maturities of our product line, vega risk is a definite area of focus in any proposed hedging program 17