Hi, I have a couple of questions in relation to chapter 14 of the CP1 notes: 1. Section 4.2 (top of page 15) refers to controls surrouding investments. I do not think I fully understand the 4th bullet point: "restructions on the maximum exposure to a single counterparty" Is this meaning you cannot invest all your funds fully in a single entity as that's risky (all eggs in one basket?) 2. Section 3.1 outlnes why approximate matching is only possible: The existence of options in either liabilities or the assets mean that full cashflows matching cannot realistically be achieved With reference to options does this mean that say a policyholder might decide to opt to take a lump sum instead of a annuity for life and we can't predict the future so it's only ever an estimation ie some will take the 'option' of a lump sum, others take 'option' of annuity? In other words cannot match this cashflow exactly? Thanks very much, Darragh
Hi Darragh In answer to your first query, you're on the right lines - this is about reducing risk of losses due to falling market prices for particular investments and, in the extreme, default by a particular counterparty. However, this control could well be a lot stronger than you describe, ensuring exposure to many counterparties for some investors such as pension schemes (rather than just more than one). Regarding your second query, that is correct - these options introduce further uncertainty in future liability cashflows making it impossible to match these with asset cashflows. Regards James
Hi James, Thanks for the response. So on point 1) this is basically saying we need to reduce losses by ensuring investors cannot invest all in one single company/sectior. As you said then ensuring exposure to many counterparties ie investing in a wide range of companies operating in different sectors of market (diversification?). What do you mean exactly when you say pension schemes? Thanks, Darragh
Hi Darragh Yes - I agree with what you've saying on point 1). This restriction would help ensure investors don't overly expose themselves to the risk of any one borrower defaulting (and the investor then suffering the loss of some or all of their associated investment) and this is the same as ensuring diversification by counterparty; so that the failure of one counterparty would have a smaller impact on an investor. I mentioned pension schemes as they are often large institutional investors that are often subject to regulation that ensures diversification of counterparty exposure. In particular, defined benefit pension schemes are usually required by regulation to pre-fund benefits promised, resulting in contributions being made, and regulation then restricts the way in which these contributions are invested by the pension scheme.
