Hi, In the notes it says that if the risks a company faces can be hedged through capital markets then economic capital would be projected over a shorter time horizon (eg 1 year), but if they can't be hedged the company may use a longer time period. Why is this? Thanks
Hi If the risk can be hedged then a market value for the matching asset/derivative is used to value the risk. As market values are volatile, the company will want to assess the impact of a risk over a short time horizon. As opposed to a risk where a market value is not available and which the company may want to use long term assumptions to value the risk and therefore model over a longer time period. Hope this helps. Thanks Em
Hi Em, I could not follow this clearly. Can you help with an example please? I have shared my understanding below. Say an insurer finds suitable derivatives to hedge interest rate risk. Market value of this derivative is x. If insurer projects assets including this derivative for a long term in order to calculate required capital, are we saying that the market value will be volatile hence impact the estimate of required capital? To avoid this volatility in estimating required capital, we will project capital for a short period. If matching derivatives are not available, how will modelling for a longer time period be beneficial for insurer?
If a risk is not hedgeable, we can't look at the market value of hedging instruments to ascertain the market-consistent cost of that risk, so we have to model. Another way to think about this could be that an insurer might decide only to look over a short-time horizon for setting its capital requirements if it has mainly hedgeable risks, because it knows that at any point (in theory, at least) it could purchase a hedging instrument to remove such risks from its balance sheet. So it only needs to be comfortable in having enough capital in place to support it through a fairly short time period. If risks aren't hedgeable in this way, the insurer might decide that it should hold enough capital to see it through a longer period of time, as it doesn't have the same security of knowing that it could use capital market hedging instruments available to deal with such risks. [Other types of risk transfer market, such as reinsurance, don't typically have the same level of certainty regarding capacity / availability as the wider capital / derivative markets.]
