September 2018 1 (iv)

[TanishaS]

Hi,
Can you please help if my understanding regarding the increase in interest rate is correct?
The company has a greater exposure to corporate bonds as compared to interest rates based on a swap curve (taking absolute value into account). An increase in the interest rate of corporate bonds will impact more than an increase in the interest rates based on a swap curve. These are negatively correlated

Thanks

 

[Lindsay Smitherman]

Apologies but I am struggling to understand these points. By 'greater exposure to corporate bonds' are you referring to this particular company having a very high SCR component relating to credit spreads widening? This does suggest that the company is more exposed to the risk of credit spreads widening than it is to the risk of interest rates increasing - but the question isn't asking about that.

Your phrase 'the interest rate of corporate bonds' is a little unclear: presumably you mean the yield on corporate bonds rather than the coupon rate? If interest rates increase, so will the yields on corporate bonds: this is a strong positive correlation. Are you thinking instead about the relationship between credit spreads widening and interest rates increasing? (This inherently feels like it would be a positive correlation too though: more likely to have defaults when interest rates are higher?)

 

[TanishaS]

Hi,
thank you for your response. For the point regarding greater exposure to corporate bonds, I had based this assumption on the higher SCR component relating to credit spreads widening- wouldn't that mean the company has purchased more corporate bonds than gilts?

Yes, I mean the yield on corporate bonds rather than the coupon rate, apologies
for example int rates=4%, corporate bonds=6%, spread=2%
int rates=5%,corporate bonds=6.5%, spread=1.5%
in above case of narrowing of the credit spread, when corporate bonds do not increase by the same percentage as the interest rates- would this mean they are negatively correlated?

Thanks

 

[Lindsay Smitherman]

If interest rates increased by 1% then the yield on corporate bonds would also be expected to increase by 1% (ignoring any impact on the spread) - assuming an increase throughout the relevant yield curve. If anything, an increase in interest rates would be more likely to result in credit spreads widening (higher chance of default due to the pressure from the greater cost of borrowing and a potential negative impact on customer demand) rather than credit spreads narrowing - hence my comment about more likely to be positively correlated.

 

[TanishaS]

Hi
If we see the examiner report for 1(vi) for increase in interest rates, it states longevity risk would reduce as liabilities are discounted using a higher yield curve and later states that-
The components of SCR driving the risk margin are unlikely to change as interest rates are unlikely to contribute to non-hedgeable risks

as SCR for longevity risk is reducing, would it not reduce this component used in risk margin as well?

Thanks

 

[Em Francis]

Hi
If we see the examiner report for 1(vi) for increase in interest rates, it states longevity risk would reduce as liabilities are discounted using a higher yield curve and later states that-
The components of SCR driving the risk margin are unlikely to change as interest rates are unlikely to contribute to non-hedgeable risks

as SCR for longevity risk is reducing, would it not reduce this component used in risk margin as well?

Thanks

Yes that's a fair observation, but this is likely to be relatively second order.