Market-consistent valuations

[echo20]

Hi, help with a small conceptual misunderstanding would be appreciated! -->

Chap 18, p. 15 (section 3.2): The core reading says that by using market-consistent techniques to value liability cashflows, the market and credit risk are appropriately allowed for. But say, e.g. you have a fixed liability in 10 years, valued by a 10 year zero coupon bond. Credit risk would lower the price of the ZCB, but the company still has to meet the liability, so why would a lower liability value be appropriate?

 

[Mark Willder]

Chap 18, p. 15 (section 3.2): The core reading says that by using market-consistent techniques to value liability cashflows, the market and credit risk are appropriately allowed for. But say, e.g. you have a fixed liability in 10 years, valued by a 10 year zero coupon bond. Credit risk would lower the price of the ZCB, but the company still has to meet the liability, so why would a lower liability value be appropriate?

Market-consistent techniques value the cashflows using risk-free rates. So we should adjust the ZCB to be risk-free, ie by reducing the return.

Contrast this with the traditional approach of using the expected return on the assets. If we are investing in corporate bonds we would value the liabilities using a higher rate of interest (see the second paragraph of Section 3.2 on pg 14). As you say, this higher expected return is achieved because of the higher market and credit risk of the corporate bond.

So the traditional approach undervalues the liabilities (by using a high interest rate) and so effectively takes advance credit for the market and credit risk premiums. Whereas market-consistent techniques have appropriately allowed for these risks (as they take no credit up front for the risk premium).

I hope this helps.

Best wishes

Mark

 

[echo20]

Thanks for taking the time to answer all my queries, Mark - all very clear and now understood!

 

[scarlets]

If you're holding a corporate bond compared to a govt bond to match that liability, does this mean you still have to use risk free rate (maybe adjusted for illiquidity premium) to value the liability?

 

[Mark Willder]

If you're holding a corporate bond compared to a govt bond to match that liability, does this mean you still have to use risk free rate (maybe adjusted for illiquidity premium) to value the liability?

The idea behind market-consistent valuations is that the value of the liabilities should be unaffected by the actual assets held. So, if two insurers have identical liability cashflows (but one holds corporate bonds and the other government bonds) the two insurers should place the same value on the liabilities.

Both insurers would use the risk free rate to value their liabilities. They could possibly use a higher rate to allow for the illiquidity premium as you suggest.

Best wishes

Mark

 

[calibre2001]

The idea behind market-consistent valuations is that the value of the liabilities should be unaffected by the actual assets held. So, if two insurers have identical liability cashflows (but one holds corporate bonds and the other government bonds) the two insurers should place the same value on the liabilities.

Both insurers would use the risk free rate to value their liabilities. They could possibly use a higher rate to allow for the illiquidity premium as you suggest.

Best wishes

Mark

Hi Mark,

I agree with that theory on Market Consistent Valuation.

But SA2 September 2007 Q1 ii) (d) suggests that holding almost identical assets could change the realistic liabilities. See the second para below

Since the market consistent valuation approach does not capitalise yields in excess of risk-free rates, a move away from higher yielding bonds has no direct impact on realistic liabilities.

The duration of the bonds is unchanged and so the underlying volatilities should also be broadly unchanged. However, the removal of credit risk might reduce the overall volatility of these assets. This would reduce realistic liabilities.

I am just wondering how the reduced volatility reduces liabilities? If it is already valued at risk free rate, how can it be lower? Besides, wouldn't a lower IR increase the liability instead? Or is it saying that the market price of the liabilities just reduces due to perception of less risk?

 

[Mark Willder]

Hi Mark,

I agree with that theory on Market Consistent Valuation.

But SA2 September 2007 Q1 ii) (d) suggests that holding almost identical assets could change the realistic liabilities. See the second para below


Quote:
Since the market consistent valuation approach does not capitalise yields in excess of risk-free rates, a move away from higher yielding bonds has no direct impact on realistic liabilities.

The duration of the bonds is unchanged and so the underlying volatilities should also be broadly unchanged. However, the removal of credit risk might reduce the overall volatility of these assets. This would reduce realistic liabilities.

I am just wondering how the reduced volatility reduces liabilities? If it is already valued at risk free rate, how can it be lower? Besides, wouldn't a lower IR increase the liability instead? Or is it saying that the market price of the liabilities just reduces due to perception of less risk?

September 2007 is an old question written when the Core Reading terminology was slightly different, which perhaps explains the inconsistency.

I think the solution here is referring to the RCM (which is on the liability side of the realistic peak 2 balance sheet). The RCM includes a stress related to credit risk and hence will be affected by the choice of bonds even if a truly market-consistent valuation of the liabilities would not be.

Best wishes

Mark