AFIR Graf Kling Russ

Stefan Graf AFIR Colloquia Madrid | June 2011
Financial Planning and Risk-return Profiles

Stefan Graf, Alexander Kling, Jochen Ru
Page 2
Financial Planning and Risk-Return Profiles Stefan Graf, Alexander Kling, Jochen Ru
Agenda
Motivation Assessing products risk-return profiles existing methodologies Risk-return profiles by means of stochastic modeling Conclusion
Page 3
Motivation
Government-run pay-as-you-go systems suffer from demographic changes
demand for private old age provision increases
How to choose optimal products?

Vast body of literature on determining optimal (often dynamic) asset allocations mostly using expected utility approaches Really practicable for typical client?
Page 4
Motivation
Contribution
Introduce methodology on how to derive risk-return profiles and compare them to existing approaches
Quantitative analyses of common products with and without investment

guarantees
Page 5
Products under consideration

Products without embedded guarantees
Investment in equity and balanced fund
Products with money back guarantee

Static option-based product (underlying + put) (Dynamic) CPPI strategy on a client individual basis (iCPPI)
Products with savings premium guarantee

(Dynamic) CPPI strategy implemented in a mutual fund and thus managed on a collective basis (CPPI high watermark fund)
Page 6
Agenda
Motivation Assessing products risk-return profiles existing methodologies Risk-return profiles by means of stochastic modelling Conclusion
Page 7
Assessing the risk-return profile
Sample illustration
Underlying investment vehicle is projected assuming some (constant) deterministic performance Products maturity benefit is then calculated accordingly
Page 8

Sample illustration*, e.g. equity fund vs. CPPI high watermark fund
Equity Fund 250,000 250,000 CPPI high watermark fund
200,000
200,000
150,000
150,000
100,000
100,000
50,000
50,000
0 0%
*12
0 3% 6% 9% 0% 3% 6% 9%
year-single premium investment
Page 9
Sample illustration - pitfalls

Asset allocation neglected
Lack of volatility conceals path-dependant effects e.g. reallocation of risky and riskless assets in CPPI products
Page 10
Backtesting
Underlying investment vehicle is projected assuming it had been invested in the past (according to some time series) Products maturity benefit is then calculated accordingly
Page 11

Backtesting*, e.g. equity fund vs. CPPI high watermark fund
Equity Fund 250,000
250,000 CPPI high watermark fund
200,000
200,000
150,000
150,000
100,000
100,000
50,000
50,000
0
Equity exposure
*Single
0
Bond exposure Equity exposure
premium investment in MSCI World and German Government Bonds from 1998-2009
Page 12

Backtesting - pitfalls
Each product can win by choosing appropriate time-series and timeframe
Incentives to design products that had been performing well in the

immediate past
Page 13
Agenda
Motivation Assessing products risk-return profiles existing methodologies Risk-return profiles by means of stochastic modeling Conclusion
Page 14
Risk-return profiles
Stochastic modeling of
Equity (modified (Heston, 1993)) Interest rates (Cox et al., 1985)
Derive maturity benefit by

Generating equity and interest rate scenarios Modeling fund management decisions Modeling products investing in various funds
Assess products risk-return profile by estimating the probability distribution of maturity benefits
Page 15
Risk-return profiles
Quantitative results
Internal rate of return 15.00% 13.00% 11.00% 9.00% 7.00% 5.00% 3.00% 1.00% -1.00% -3.00% -5.00%
Equity Fund 50% iCPPI Option Based Product Median Expected return Balanced Fund CPPI high watermark fund
Internal rate of return 15.00% 13.00% 11.00% 9.00% 7.00% 5.00% 3.00% 1.00% -1.00% -3.00% -5.00%
Equity Fund 50% iCPPI Option Based Product Median Expected return Balanced Fund CPPI high watermark fund
90%
Sample Illustration
90%
Sample Illustration
Single premium
Regular premium
Page 16
Agenda
Motivation Assessing products risk-return profiles existing methodologies Risk-return profiles by means of stochastic modelling Conclusion
Page 17
Conclusion and further research

Conclusion
Existing approaches provide insufficient information and may lead to misselling Introduced methodology provides appropriate assessment of products risk-return profile
Further research
Extension to retirement phase products? Model risk? e.g. modeling of inflation,
How to communicate the information appropriately (to financial advisors

and clients)?
Page 18
Thanks for your attention

Contact details
Stefan Graf Alexander Kling Jochen Ru s.graf@ifa-ulm.de a.kling@ifa-ulm.de j.russ@ifa-ulm.de

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Stefan Graf AFIR Colloquia Madrid | June 2011

Financial Planning and Risk-return Profiles

How to choose optimal products?

Quantitative analyses of common products with and without investment

Products under consideration

Products with money back guarantee

Products with savings premium guarantee

Assessing the risk-return profile

Assessing the risk-return profile

year-single premium investment

Assessing the risk-return profile

Sample illustration - pitfalls

Assessing the risk-return profile

Assessing the risk-return profile

Assessing the risk-return profile

Incentives to design products that had been performing well in the

Derive maturity benefit by

Conclusion and further research

How to communicate the information appropriately (to financial advisors

Thanks for your attention

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