As you know that LDI is hot topic in Europe. Frankly, I am from Asia so I do not have any real experience in this topic. But as I am taking SA6(which I should be taking SA2 
), I am forced in trying to understand this issue.
So, I would like to share my thought on leveraged LDI(based on what I can imagine) which I think it might be sufficient to prepare for the exam:
Suppose:-
pension scheme liabilities = 10 mil
pension scheme backing assets = 7.5mil => deficit of 2.5mil
LLDI can be viewed as a fund which borrow money to invest.
(in real case, LLDI invests in portfolios of derivatives, such as swaps. Swap investment is a form of leverage investment as smaller margin/collateral required to back the movement of value of derivatives <-- cost of financing)
The scheme want to hedge the pension liabilities against inflation and interest rates risks (eg. liabilities will increase > 10mil if interest rate decrease), scheme can choose to take the 10mil position by investing in LLDI fund (effectively the scheme take over the position of 10mil borrowing in LLDI).
To take this position, scheme can choose the amount of leverage, say 2 (which means placing a collateral of 5 mil with the LLDI fund). In real case I think scheme need to finance the borrowing cost, which might possible to pay from own pocket or returns from collateral of 5 mil.
Suppose now interest rate increase
--> pension liabilities value , say decrease to 9mil
--> if the LLDI fund hedges effectively, then there will be equivalent loss from LLDI investment.
See what happen to LLDI investment:
--> initial borrowing was 10 mil for scheme to have 10mil of asset holding in LLDI (with 5 mil collateral)
--> assume collateral value remains 5 mil, the scheme's asset holding in LLDI is 9mil (say due to 1 mil loss as interest rate increase)
--> this means our leverage position increases, can be viewed as we owe 10 mil but our underlying assets is worth only 9 million, so in total we owe 11 million with 5 million of collateral ==> leverage ratio of 2.2
If interest rate increase a lot, then based on above argument, our leverage position is high. Additional collateral will be required to reduce the leverage ratio to acceptable level. But, this additinoal amount of collateral can be mitigate if the scheme able to invest in assets that move with LIBOR (need to bear in mind that "haircut" may apply if collateral is riskier asset than cash)
The argument is similar for interest rate decrease
--> liabilities value increase, but gain from LLDI
Please take note that there might be other form of arrangement in collateral or leverage method, but logic should be similar.
Now we go to see the deficit position.
If above hedge is perfect, then scheme still have deficit of 2.5mil.
As the deficit is more stablised and crystallised, 2.5mil can be invested in risky assets to achieve higher returns to close up the deficit gap.
In short, we can see LLDI as
We borrow the amount equal to liabilities value to invest in assets which will move closely with liabilities value due to interest rate or inflation.
Then we placed collateral(usually from current pension backing asset) and service the cost of borrowing.
We then use the remaining assets to invest in riskier assets the hope to generate higher returns to fund the deficit.
Look at some scenarios
- risky assets investment loss entirely, scheme need to make good of 5 mil or more.
- risk assets generate zero returns, scheme need to make good of 2.5 mil or more.
- risky asset generate 100% returns, scheme will be closely funded.
However, we see that this method is complex and care needed to deal with borrowing cost, collateral arragement, collateral investment, and risky assets investment. As it also involves derivative investment in the LLDI itself, there will be risks associated with derivative holdings.
I hope my explanation can give better picture just for the purpose of writing the exam. Please correct me and comment to allow me to have better understanding (but before next monday..hahaha..thanks!)
Last edited by a moderator: Sep 17, 2008
