L
Logarithm n Blues
Member
Hi Forum,
I'm a bit confused by this answer and I just want to see if someone can help me get my head around what's happening.
The question asks:
In the examiners' report answer is the following..
and im having trouble interpreting and understanding this.
I thought through the answer as follows:
Or are we talking about discretionary liabilities? in which case this still feels odd to me given the set up of the question?
Any help or pointers would be appreciated.
I'm a bit confused by this answer and I just want to see if someone can help me get my head around what's happening.
The question asks:
An insurance company’s liabilities are sensitive to interest rates. The company wishes
to reduce its exposure to interest rate risk via the use of swaps.
(ii) Explain how:
(a) These swaps could be valued in the company’s accounts.
(b) Their values will move if future interest rates are lower than expected.
In the examiners' report answer is the following..
If anticipated future interest rates become lower than expected at the inception of the swap, the value of the asset held by the insurer will decrease, but this will offset the increase in their other assets (assuming the durations match) making the impact less volatile on the liabilities side.. [5]
and im having trouble interpreting and understanding this.
I thought through the answer as follows:
- The stated problem is that the liabilities are sensitive to interest rate changes. I guess that this means that there are some long term liabilities and when interest rates fall these liabilities are discounted by lower interest rates and so the present value of the liabilities increases. I'm guessing that the increase in liabilities is larger than the increase in asset values otherwise the assets would already be offseting the liabilities and there would not be a problem. If the assets already move much more than the liabilities then I would say that the issue was that the assets are sensitive to interest rates, not the liabilities.
- Therefore the insurer is exposed to the risk of low interest rates.
- Therefore the insurer would naturally take the leg of the swap where they would be paying out at a floating rate of interest and receiving a fixed rate of interest. This way when interest rates are low they would benefit and this would offset the problem with volatile liabilities.
- So if future interest rates are lower than expected then the insurer is now holding a swap contract where they pay only low floating rate values but they are still receiving the same fixed rate values. Surely this contract looks great to the insurer and has positive value?
- So I would say that the value of the swap INCREASES when rates are low, and that this helps to offset the increasing value of liabilities (by adding volatility to the assets in order to more closely match. the assets already increase in value but not by enough!)
Or are we talking about discretionary liabilities? in which case this still feels odd to me given the set up of the question?
Any help or pointers would be appreciated.