Mcev

[andy orodo]

Can anyone help me understand how assumptions are set using an MCEV calculation?

From the flash cards it says that the risk discount rate and the investment return assumptions (in a deterministic model) are set as the risk free rate. It says that any extra return on top of the risk free rate is cancelled out completely by the extra risk incurred, hence it is appropriate to do this. Is that true?

High risk assets will have a high volatility of returns and that is attributable to the extra risk but it would also have a higher expected return than safer assets. Is the extra expected return on riskier assets being ignored in the MCEV valuation? Is it right to say that changing investment strategy makes no impact on an MCEV valuation?

 

[mugono]

Hi Andy,

I'll give it a go but I would appreciate any comments people may have!

From my understanding of MCEV, the key idea is that returns are realised when earned and not before! (This was a problem with traditional embedded value because companies could do just that, which is not prudent!

Strictly speaking, the higher expected return earned on riskier assets isn't ignored. Under MCEV it is discounted at this higher return (i.e. there is no impact).

The implication of this is that the riskiness inherent in cashflows should be discounted at higher rates of interest to take account of their riskiness.

The rationale behind using risk free rates is to simplify the calculation! It borrows the ideas touched in CT8 around risk neutrality.

Under certain conditions... we can produce results in which the real world measure and the risk neutral measure produce identical results

In answer to your final question:

You are right... the investment strategy should have no impact on an MCEV calculation.

What it would effect however would be the implied discount rates that many companies would calculate when presenting their results.

This is my interpretation of MCEV but would welcome any views on this.

This is what I have picked up reading around and not from the course I must add!!

Hope this helps

 

[jashworth]

Hello Andy,

My understanding of MCEV versus EEV is based on what my company does. Here goes:-

An MCEV is calculated using investment returns equal to the risk-free rate (based on an average of 5 year and 10 year interest rate swaps). This is as mugono states to simplify things. The risk-free rate is taken as the yield an investor would accept in exchange for a higher return on a riskier asset -ie the certainty equivalent rate.

The MCEV risk discount rate is taken as this risk-free rate plus a margin for undiversifiable risks.

An EEV is also calculated using actual investment returns that is including an equity risk premium and a property risk premium over fixed interest returns. The fixed interest return is taken as the average of the 10 and 15 year gilts.

A risk discount rate is then calculated such that when applied to the EEV profit flows it gives the same result as the MCEV calculation. This is called 'calibration'. The risk margin is then the difference between the Calibrated RDR and the MCEV RDR.

The idea behind this I believe is that the parameters for EV calculations are less subjective and more transparent and also making possible meaningful comparisons with other companies' results.

What I think was happening with the traditional EV was that using the higher returns for risky assets but discounting at a lower RDR in effect capitalised those profits too early or before they had been earned.

Please - anyone correct me if I have made any mistakes in my understanding here.

Does this help Andy?

 

[Mike Lewry]

Two great posts from mugono and jashworth.

I'd like to reassure anyone worried by jashworth's post, that he touches on material that goes into SA2 territory, so although I think it's helpful additional info on MCEVs, it isn't required knowledge for the ST2 exam.

(To explain the EEV abbreviation in jashworth's post: As well as general concepts of embedded values and market-consistent versions of them, there are sets of EEV - European EV - Principles and MCEV Principles that have been published by a European body to help achieve consistency and transparency across Europe. Elsewhere in the world, there can be other ways of calculating EVs that don't necessarily do things the same way.)

In the earlier posts, the statement "the investment strategy should have no impact on an MCEV calculation" can be broadly true for simple models of simple products, but in practice won't be quite right. For example:

(1) the value of guarantees offered on some investment policies will depend on the investment strategy followed (eg fully hedged or not)

(2) some EV models will allow for management actions to mitigate against adverse scenarios and the effect of these will differ depending on the investment strategy adopted.