Can someone explain how using derivatives can increase capital when used for hedging? For example, we have a cost of guarantee of X and we hedge using a derivative which costs us Y. Liability reduces by X and asset reduces by Y. X is calculated using market consistent model. I suppose Y = X + profit margin. Isn't Y > X therefore the reduce in asset is more than reduce in liability and the capital position become worse? Thanks
Yes, I'd agree with your logic above that realistically the cost of the derivative may exceed the reduction in your liabilities. However, the answer depends on what measure of capital we're looking at. Peak 1 is calculated using prudent assumptions and also requires a LTICR and possibly a RCR. If the prudence in these calcualtions outweighs the profit margin in the derivative then the capital position is improved. Similarly, Peak 2 capital may be improved by reducing the RCM by more than the cost of the margin in the derivative price. ICA or Solvency II capital may improve if the derivative improves the 99.5% scenario. But if we look at the realistic position without any of the above regulatory margins then our market-consistent value is actaully a little worse as you suggest. Best wishes Mark
