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Business School

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ACTL4303 AND ACTL5303
ASSET LIABILITY MANAGEMENT
Course Outline
Semester 2, 2015
Course Overview

Greg Vaughan

Course Coordinators
Greg Vaughan
–  Sessional Lecturer for the course
–  Email: gregory.vaughan@unsw.edu.au
–  Consultation hours: by appointment (Mondays 5-6pm)

Professor Michael Sherris
–  Telephone: 9385 2333
–  Email: m.sherris@unsw.edu.au
–  Consultation hours: by appointment (Mondays 4-5pm and Wednesdays
5-6pm)

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Course Aims
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To provide students with coverage of the Institute of Actuaries of Australia part II professional
syllabus.
To provide an understanding of the main features of investors, investment markets, investment
classes and investment theories.
To develop an understanding of asset liability models, their application to asset allocation
decisions and the investment management process.
To be able to assess asset liability models along with relevant applications to different types of
liabilities.

The course builds on prior courses in the actuarial program, in particular ACTL3004 Financial
Economics for Insurance and Superannuation for undergraduate students and ACTL5109
Financial Economics for Insurance and Superannuation for postgraduate students.
It is one of three UNSW courses that cover the Actuaries Institute Part II syllabus, with this course
covering the Part IIB – Investment and Asset Modelling syllabus.
An exemption from the Institute of Actuaries of Australia Part II course is based on obtaining an
average of 75% in ACTL4001, ACTL4002 and ACTL4303 or ACTL5100, ACTL5200 and
ACTL5303.

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In particular students should be aware of: the valuation methods and principles. Demonstrate an understanding of the methods used for valuation of the common forms of debt. based on the liability profile of a fund. theories from behavioral finance Construct. Apply asset assumptions. prevailing industry expectations. Derive consistent asset assumptions for asset models. identify the characteristics of different types of asset models. 4 . Describe and critically evaluate different approaches to asset allocation. and be able to critically evaluate these theories including: the efficient market hypothesis. Critically evaluate the appropriateness of an asset model for a given context. to real world situations. and other practical considerations such as tax. the collapse of speculative bubbles. multi-factor pricing models. data requirements and sources. and be able to: define appropriate investment objectives based on the liability profile of a fund. the capital asset pricing model. and the linkages contained within asset models. shocks to the economic system and cyclical/structural changes. understanding the relationship between risk and return and recognizing risk factors which include issuer default. property and derivative securities. the implicit assumptions and limitations of these models Demonstrate an understanding of the application and limitations of the major economic and financial theories relevant to investment. taking into account historical date. critically evaluate and apply asset models of a stochastic nature that are appropriate to the management of liabilities. specify appropriate investment constraints.Learning Outcomes Describe and critically discuss the characteristics and behavior of different Investment types under different economic conditions. contemporary investment literature. systemic liquidity. counterparty failure. equity.

Stuart Klugman and John Shepherd. Richard Lyon. Zvi Bodie. Alex Kane. Institute of Actuaries of Australia UAM (ACC) • C Bellis. Understanding Actuarial Management. Other reference texts are: Fitzherbert R (2004) Investment Principles for Actuaries. Institute of Actuaries of Australia & Society of Actuaries. and Alan Marcus McGraw Hill. The text is used to emphasise the practical aspects of the topics in the context of the Course Outcomes. Second Edition 5 .Textbooks The prescribed textbook for this course is: Investments. 2014 ISBN13: 978-0-07-786167-4 Many concepts in this text will have been covered by students in previous courses.(2010).

. and J. S.Pirie. Ch 6 & 7. J. The Research Foundation of CFA Institute Gootkind. (2012) Fundamentals of Credit Analysis (from Petii.L. C.. Taliaferro. (2012) Equity Valuation and Inflation: A review . M. Financial Analysts Journal.. Where is the Value Premium?. No 2 pp 43-58 Clarke R. A.. 2 pp 64-82 Phalippou.Pinto and W. N (2014) Facing the Reality of Bubble Risk. L (2008). de Silva H & Thorley S (2002). July-August 2014 pp 22-24 Wilcox. B. Fixed Income Analysis. CFA Institute Magazine. (2014) The Low Risk Anomaly: Decomposition into Micro and Macro Effects. Vol 64. M.Required Readings Required Readings (to be provided on Course web site): APRA Prudential Practice Guide (2013) Investment Governance Scowcroft.2 pp 41-48 Baker.E. Financial Analysts Journal.). Kobor A. Bradley and R. CFA Institute) Berekelar A. The Sense and Nonsense of Risk Budgeting. Vol 70. Understanding Momentum.S. B. (2013) Real Property In Australia. Vol 61 No.J. Sefton (2005). Portfolio Constraints and the Fundamental Law of Active Management Sep-Oct pp48-66 Sargen. No. Financial Analysts Journal Sep-Oct pp63-75 Heffernan. Tsumagari M (2006).L. Financial Analysts Journal.6 6 .

Kroner and L.P.D’Arcy and R. Ahlgrim.F. K. Financial Analysts Journal.Gorvett. A..Siegel (2011) A Supply Model of the Equity Premium.C.. E (2013) Rethinking the Equity Risk Premium (a summary).C. Dynamic Strategies for Asset Allocation. The Research Foundation of CFA Institute Maginn.W. K. Chapter 5 Perold. & Sharpe. (1988). R. Managing Investment Portfolios. J et al. S. Modelling Financial Scenarios: A Framework for the Actuarial Profession 7 .. Jan – Feb pp 16-27. The Research Foundation of the CFA Institute Dimson.B. W.Required Readings Required Readings (continued) Grinold.

Teaching and Learning Approach Review text and reference material prior to class meeting Lectures introduce and explain concepts in the student learning outcomes of the Course Each lecture will provide an overview of the topics and will focus on explaining concepts and issues along with applications and practical issues. answers to discussion issues Development discussion skills 8 . Participate in class as required – discussion and questions. The role of the lecture is also to provide students with an opportunity to ask questions and discuss the major aspects of the topic with other students.

Doing well in this course Develop an approach to understanding main concepts Develop detailed understanding of theory Integrate concepts Read widely – text and articles on web Work consistently – reading. summarising 9 . reviewing.

Moodle Course uses Moodle Material for course: Course outline Lecture slides Assignment Academic Research Papers of interest Websites of interest Discussion forum 10 .

Assessment Assessment Task Weighting Length Due Date Mid-Session Exam 15% 1 hour Monday 8 September Report 15% 4000 words As in schedule Final Exam 70% 2 hours University Exam Period Total 100% 11 .

Infrastructure .Course Structure Date Topic Capital markets 1 28 July Introduction and investment background 2 4 August Risk. absolute return assets 9 22 September Capital Market Expectations and Asset Allocation 10 6 October Asset Liability Models 11 13 October Futures Options and Derivatives 12 20 October Currency and International Diversification. Performance measurement and attribution 13 27 October No Lecture Asset classes and analysis Investment management process Asset Liability Models and Applications 12 . 5 25 August Equity valuation and Portfolio Management 6 1 September Interest Bearing Securities 7 8 September Mid-Session Exam. Risk Management 8 15 September Property. return and portfolio theory 3 11 August Asset Pricing and Market Efficiency 4 18 August Economic and financial theories.

report writing and exam preparation resources Subject specific support Student support program 13 . such as referencing guides. including: Academic skills workshops Consultation services for students with individual or small group learning needs Printed and online study skills resources.Educational Development Unit Education Development Unit The Education Development Unit (EDU) is part of the Learning & Teaching Portfolio and provides free and confidential learning support to students at the Australian School of Business.

Occupational Health & Safety – Student Information Inform your Lecturer/Tutor: -  Of hazards ie wet floors. inform your lecturer/Tutor and/ or contact Security on 9385 6666 14 . loose wires or trip hazards -  Insufficient seating in lecture theatre/classroom -  Of Bullying. leaky ceiling. discriminatory and anti-social behaviour If an alarm sounds: -  Immediately gather up your possessions -  Move in an orderly fashion to the nearest exit -  Follow directions of the building emergency team and security -  Congregate a safe distance from the building -  Do not re-enter the building unless instructed to do so In the event of an accident or emergency.

 MARCUS   .  KANE.  financial  assets   •  Risk–return  trade-­‐off  and  the  efficient  pricing     •  Financial  crisis  2008     •  ConnecCons  between  the  financial  system   and  the  “real”  side  of  the  economy   •  Lessons  learned  for  evaluaCng  systemic  risk   1-15 15 INVESTMENTS  |  BODIE.Chapter  1  Overview   •  Role  of  financial  assets  in  the  economy:  Real   vs.

  buildings.   •  Examples:  Stocks.  MARCUS   .  bonds   knowledge  used  to   produce  goods  and   services     1-16 16 INVESTMENTS  |  BODIE.  KANE.Real  Assets  vs.     •  Examples:  Land.  Financial  Assets   Real  Assets   Financial  Assets   •  Determine  the   •  Claims  on  real  assets.  machines.   producCve  capacity  and   do  not  contribute   net  income  of  the   directly  to  the   economy   producCve  capacity  of   the    economy.

Universal  Bank  Activities   Investment  Banking   Commercial  Banking   •  Underwrite  new   •  Take  deposits  and  make   securiCes    issues   loans   •  Sell  newly  issued   securiCes  to  public  in  the   primary  market   •  Investors  trade  previously   issued  securiCes  among   themselves  in  the   secondary  markets   1-17 17 INVESTMENTS  |  BODIE.  KANE.  MARCUS   .

 MARCUS   .  which  benefits  the  firms  that   need  to  raise  capital  as  security  can  be  sold  for  the   best  possible  price   1-18 18 INVESTMENTS  |  BODIE.  KANE.Financial  Markets  and  the  Economy   •  The  InformaConal  Role   •  Capital  flows  to  companies  with  best  prospects   •  ConsumpCon  Timing     •  Use  securiCes  to  store  wealth  and  transfer   consumpCon  to  the  future   •  AllocaCon  of  Risk     •  Investors  can  select  securiCes  consistent  with   their  tastes  for  risk.

 MARCUS   .  KANE.Financial  Markets  and  the  Economy   •  SeparaCon  of  Ownership  and  Management   •  Agency  problems  arise  when  managers  start  pursuing   their  own  interests  instead  of  maximizing  firm's  value   •  Mechanisms  to  miCgate  agency  problems:   •  Tie  managers'  income  to  the  success  of  the  firm  (stock   opCons)   •  Monitoring  from  the  board  of  directors   •  Monitoring  from  the  large  outside  investors  and   security  analysts   •  Takeover  threat   1-19 19 INVESTMENTS  |  BODIE.

ASX Bad investment decisions by companies can be made within ‘clean’ corporate governance structures. 20 .Corporate Governance “The framework of rules. relationships. systems and processes within and by which authority is exercised and controlled in corporations.” .

ASX Corporate Governance Principles and Recommendations (2010) “if not. not the CEO •  Majority of board should be independent directors •  Audit committee only non-executive directors with a majority of independent directors 21 . why not” ASX Listing Rule 4.10.3 – companies make annual disclosure of extent of compliance with Recommendations Key elements include: •  Independent Chair.

The “two strikes” rule • Corporations Amendment Act 2011 • Previously no consequences when a board ignored a negative vote on a remuneration report • First strike when a company’s remuneration report receives 25% or more ‘no’ vote on votes cast. • Second strike the following year will spill the board 22 .

1 •  Companies required to disclose market sensitive information to ASX immediately •  Exemptions include incomplete proposal or negotiation •  If the ASX considers there is or is likely to be a false market it may compel a company to clarify •  Objective is to minimise insider trading and to maintain confidence in the market 23 .Continuous disclosure – ASX Listing Rule 3.

not a normal country specific business cycle downturn •  Excessive debt accumulation poses greater systemic risks than are apparent during a boom •  Loose monetary policy stimulates growth unsustainably •  Private sector borrowing binges inflate housing and stock prices beyond sustainable levels •  The economic contraction from a financial crisis is much more severe and extended (avg 4 yrs) than from a business cycle downturn.Why was the 2007-2009 downturn so severe? •  A global financial crisis. and recovery takes longer (avg 10 yrs) – Reinhart and Rogoff 24 .

high saving countries with aging populations (Japan and Germany) •  The US was a popular and willing creditor for these savings •  ‘This-Time-Is-Different’ Syndrome – Fed Chairman Alan Greenspan frequently argued financial innovations (securitization) enabled risk to be managed better than ever before. Chinese trade surplus. 25 .How the Second Great Contraction (2007-2009) happened (1) •  Global savings glut from Middle Eastern oil earnings.

Finland and Sweden 1991.private or both) •  Financial liberalization A country can move from moderate debt to high debt quickly if it loses control of its current account and budget position 26 . Norway 1987. capital inflows •  Sustained debt buildup (public. Japan 1992) •  Rising asset prices •  Slowing real economic activity •  Large current account deficits.How the Second Great Contraction (2007-2009) happened (2) There are some common precursors to severe financial crises which the US shared with previous episodes (Spain 1977.

27 .How the Second Great Contraction (2007-2009) happened (3) •  Mortgage loans to ‘sub-prime’ borrowers with low initial interest rates moved from <10% to 20% of loan issuance •  Securitisation of sub-prime debt fuelled the fire •  The US financial sector grew from 4% of GDP in mid-1970’s to 8% of GDP in 2007. •  Ratio of household debt to GDP was stable at around 80% until 1993 before moving to 130% by mid 2006 •  In the decade to 2006 US house prices appreciated by 92% in real terms. compared to 27% from 1890 to 1996.

borrowers struggled to pay loans and could not refinance in soft market •  Foreclosures weakened prices and equity in loans went negative •  In the US it was relatively easy for borrowers to walk away from their loans •  The ‘originate to distribute’ model meant loans were not well supervised as they soured •  Mortgage Backed Securities (MBS).How the Second Great Contraction (2007-2009) happened (4) •  As Adjustable Rate Mortgages reset. often a significant part of Collaterised Debt Obligations (CDOs) lost value •  The assets of the ‘shadow’ banking system were impaired 28 .

overwhelming underwriters (AIG) •  Aggregation of risk within MBS was. got nervous (Lehman) •  The GFC involved a failure of regulation (not in Australia) to prevent a massive systemic vulnerability 29 . with the benefit of hindsight. poorly modeled •  Ratings agencies were conflicted in their optimistic rating of MBS and CDOs (issuers paid them) •  Party finally stopped when short term lenders to the ‘shadow’ banking system. weaker prices.How the Second Great Contraction (2007-2009) happened (5) •  Impaired balance sheets drove more foreclosures. more negative equity. more loan delinquency •  Credit Default Swaps enabled risk to be moved and intensified.

strong terms of trade •  Room to move with monetary and fiscal stimulus •  ‘go early. to developments in the future is virtually without peer” – Glenn Stevens RBA Governor May 2008 •  Little government debt.Why not in Australia? •  Australia’s supervision of banks by APRA was interventionist rather than laissez faire •  “the capacity to respond. Treasury secretary advice to government •  Australia’s response to the GFC praised by the IMF •  But our household debt is high 30 . go households’ – Ken Henry. growing economy. if need be. go hard. budget in surplus.

Australia’s aggregate debt level is not high but our household debt is 31 .

Change in debt-to-GDP percentage. national sources. McKinsey Global Institute analysis 32 .The world is finding it very difficult to deleverage. 2007-14 Source: Haver Analytics .

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How a leveraged economy recovers Source: McKinsey 2012 Debt and deleveraging 34 .

 capital  markets   • Types  of  money  market  instruments   • Capital  market  securiCes:   •  Bonds   •  Equity   •  DerivaCves   1-35 35 INVESTMENTS  |  BODIE.Chapter  2  Overview   Asset  alloca6on  →  Asset  classes   • Money  markets  vs.  MARCUS   .  KANE.

International equities by country MSCI All Country World Index (ACWI) June 2015 36 .Asset class structures .

Figures as at June 2015 37 .Asset class structures -  Australia is a high payout market Source: MSCI. S&P/ASX.

45t (July 2015).Asset class structures -  equities by sector S&P/ASX 200 Market Cap is $1. 38 . MSCI ACWI Market Cap is US$38t.

Other Topics •  •  •  •  Trading in the Australian market Regulatory environment The Australian superannuation system Taxation and dividend imputation 39 .

redeemable or convertible 40 .Equity Ordinary (Equity) Shares –  Limited liability –  Residual claim –  Return in the form of dividends & capital appreciation Preference Shares –  Fixed dividends (limited) –  Priority over ordinary –  May be cumulative.Capital Market .

Primary Market Primary Market –  Initial Public Offerings –  Seasoned New Issues Types of Primary Market –  Public Offering –  Private Placement 41 .

Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration Dominated by institutions For sophisticated and professional investors Professional investor as per Financial Corporation Act 1974 (Commonwealth) 42 .

Secondary Market Secondary –  Existing owner sells to another party –  Issuing firm doesn’t receive proceeds and is not directly involved –  Liquidity Centre –  Base for movement of indices –  Action and activity oriented 43 .

Markets and Market Structure Auction Market –  Convergence and execution –  ASX is an example of Auction market –  Require heavy and frequent trading –  It’s why listing requirements on ASX 44 .

Dark pools and ‘lit’ markets •  •  •  •  Dark pools are off exchange anonymous trading ‘venues’ Offered by brokers and exchanges (ASX’s Centre Point) These are alternatives to conventional ‘lit’ markets A large trade may be transacted ‘in the dark’ without having impact •  Dark pools reduce liquidity of ‘lit’ markets 45 .

Direct Market Access and algorithmic trading •  Investment managers can by-pass brokers and deal electronically directly to the exchange via Direct Market Access •  This would usually be to facilitate algorithmic trading. where trades are driven by an ‘intelligent’ program •  The conventional objective is to systematically drip trades into the market without causing market impact •  When buying. a symptom of market impact would be an increase in the sell side of the spread •  High Frequency Trading is a mischievous subset of algorithmic trading 46 .

requires shareholder (75% by value. •  Scheme of arrangement. usually conditional on certain level of acceptance. usually conditional and may include corporate restructure. unconditional so can get stuck half way. May be hostile. cash and scrip combination. •  Off market. The Takeovers Panel regulates takeover activity to ensure takeover rules are observed 47 .Takeovers Three approaches: •  On market bid (rare). can be increased if contested by interloper. Typically friendly. Cash only. 50%) by number and court approval. cash and scrip combination.

institutional superannuation funds. investment managers and brokers •  The Australian Securities Exchange (ASX) administers listing rules for companies and operating rules for brokers •  The Australian Accounting Standards Board (AASB) issues company accounting standards •  The Auditing and Assurance Standards Board releases auditing standards (eg GS007) 48 . life insurance companies and general insurance companies •  Australian Securities and Investments Commission (ASIC) regulates companies.Who regulates what (1)? •  Australian Prudential Regulations Authority (APRA) regulates banks.

arrangements or understandings that are likely to substantially lessen competition in a market •  abuse of market power through predatory pricing aimed at damaging competitors and reducing competition 49 . to prohibit for example: •  businesses acting in an unconscionable manner against their customers and against other businesses •  contracts.Who regulates what (2)? The Australian Competition and Consumer Commission (ACCC) regulates competition across businesses.

Who regulates what (3)?
•  Significant national assets, including water, energy and
port infrastructure enjoy reduced competition
•  These assets are not free to set their own prices or
access terms and conditions
•  Instead these are overseen by either the ACCC or the
Australian Energy Regulator

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APRA and superannuation funds (1)
Superannuation Prudential Standard (SPS) 530 –
Investment Governance
•  Funds must formulate specific and measurable risk
and return objectives
•  Due diligence process for the selection of
investments
•  Appropriate measures to monitor performance
•  Review objectives and strategies on a periodic basis
•  Formulate a liquidity management plan

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APRA and superannuation funds (2)
Superannuation Prudential Standard (SPS) 530 –
Formulating the investment strategy
•  Identify risk factors and associated sources of return
•  Identify how sources of return interact , the variability
of interactions and impact on overall diversification
•  Determine target exposures to these risk factors
•  Determine appropriate stress scenarios and
undertake stress testing
•  Determine asset allocation targets and ranges

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and reduced by any effective asset-liability matching.APRA and life/general insurance investment •  Prudential Standards LPS and GPS 114 specify Capital Adequacy Asset Risk Charge stress tests. •  Capital requirements are sensitive to the asset mix. •  High capital requirements can dilute the return on equity for investors 53 .

In some cases members can also construct portfolios at the individual asset level (member direct) •  Default choice must conform to MySuper simplicity 54 .Australian superannuation system •  Compulsory saving via Superannuation Guarantee •  Employers must contribute 9.5% of employees salary moving to 10% by 2021 and 12% by 2025. •  Employees can generally choose the fund in which these contributions are invested. •  Within the chosen fund members usually have investment choice via a range of diversified portfolios at different risk levels.

05t at March 2015 55 .Australian superannuation Assets of $2.

56 .

Australian superannuation Average Asset Allocation of MySuper Products – March 2015 57 .

(eg a $70 fully franked dividend is worth $100) 58 .Taxation of superannuation investment •  Income and short term net realised capital gains (<12mths) are taxed at 15% •  Long term net realised capital gains are taxed at 10% •  Imputation credits are included in taxable income then rebated •  Pension assets are tax exempt and receive the full benefit of imputation credits.

•  This is achieved by restoring the dividend to its precompany tax equivalent •  The investor’s tax rate is then applied to that gross income •  The investor receives a credit against their tax liability for the tax the company has already paid •  This credit may exceed the tax liability creating an additional benefit to the nominal dividend 59 .Dividend Imputation (1) •  The concept of dividend imputation is to remove the effect of company tax. so that the only tax impost is the investors own tax situation.

and pays company tax at 30% leaving $70 for distribution as dividend •  A $30 imputation credit is attached to the $70 dividend in respect of the company tax paid •  The superannuation fund pays 15% tax on the aggregate of the dividend ($70) and the franking credit ($30).Dividend Imputation (2) •  A company makes a profit of $100. Tax = 15%x($70 + $30) =$15 •  The superannuation fund receives a credit from the tax office of $30 against that tax liability. with the net effect that the superannuation fund receives $15 •  The dividend is worth $85 to the superannuation fund 60 .

risk measures and time horizon Forecasting with arithmetic and geometric means Study 5.7 carefully .Next week Risk.Deviations from Normality and Risk Measures 61 .4) Return distributions. return and portfolio theory Bodie Chapter 5 Nominal and real rates of return Risk premiums (spreadsheet example in 5.

return and portfolio theory Bodie Chapter 6 Risk. speculation versus fair game Risk aversion and utility values The capital allocation line and leverage Study Section 6.5 Carefully – Risk Tolerance and Asset Allocation Study Appendix A 62 .Next week Risk.

return and portfolio theory Bodie Chapter 7 Mathematics of diversification Markowitz Portfolio Optimisation Capital Allocation and the Separation Property Study Appendix A 63 .Next week Risk.

return and portfolio theory Bodie Chapter 8 Single index model Security Characteristic Line Study 8.Next week Risk.4 carefully 64 .

edu.edu.Thank you for your attention Greg Vaughan gregory.sherris@unsw.au School of Risk and Actuarial Studies ARC Centre of Excellence in Population Ageing Research University of New South Wales 65 .au Michael Sherris m.vaughan@unsw.