Derivatives: Forwards vs Futures

-
Image
  Before understanding what is derivative, let’s learn what is underlying asset. Underlying asset: Underlying asset can be real asset such as commodities, gold etc or financial assets such as index, interest rates etc. Derivatives: ·         These are financial instruments who value depend upon or is derived from some underlying asset. ·         A derivative does not have its own physical existence, it emerges out of contract between the buyer and seller of derivative instrument. ·         Its value depends upon the value of underlying asset. Hence returns from derivative instruments are linked to returns from underlying assets. ·         The most common underlying assets are stocks, bonds, commodities, market indices and currencies. ·         Derivatives are mainly used to control risks. They can be used to reduce risks (a process known as hedging) or to increase risks in order to enhance returns (speculation)   Classification of Derivatives: ·         Broadly we c
Post a comment

Can you explain Duration in layman terms?

-
Duration is one of the favourite question of an interviewer.

Simple answer:

Sensitivity in your portfolio value with respect to changes in your interest rate is called as Duration.

For ex: If i say that Duration of my portfolio is 5, then it means if i decrease 1% interest rate then there will be 5% increase in my portfolio value.

Now you will think how can you say whether portfolio value will increase or decrease


Ans: Simple point is that your portfolio value is the discounted value of your future cashflows.

X = y/(1+i)

so if you decrease your interest rate in this equation then the value of X will increase. Isn't it?

Follow us on Linkedin: Actuary Sense

Follow us on Instagram: Actuary Sense




Application Use: An actuary will want to know how much volatile his portfolio is due to interest rate because he has to match those assets with the liabilities. Assets and Liabilities are both present value of future cashflows in an insurance company while doing actuarial valuation. So it can be possible that decrease in your interest rate may leads to more increase in your liabilities than your assets and then it will be a problem. 

Just because of this immunisation concept into book which says that 

 

1.     Present Value of assets = Present value of Liabilities

2.     Duration of Assets = Duration of Liabilities

There is one more condition though but we will discuss that in upcoming articles.

 Follow us on Linkedin: Actuary Sense

 Follow us on Instagram: Actuary Sense

Comments

Post a comment

Popular posts from this blog

Overview on Solvency II in a Layman Language - Phase 1 - Actuarial

-
Image
Overview Solvency II is set of rules set by regulatory body that tells insurance company regarding how much capital should they hold. Let’s understand with the help of an example… Suppose there are 2 insurance companies i.e. Company X and Company Y Company X Company Y Assets 100 million Assets 100 million Liability 80 million Liability 80 million On the basis of only this information, what do you think, which company is financially strong ? which company is performing better ? Your answer would be that both these companies have same level of security. Now let us give you further information i.e. breakdown of asset classes Company X – Assets Company Y – Assets Equities 80 million Govt. Bonds 80 million Derivatives 20 million Corporate Bonds-AAA credit rating 20 million Now te
Read more

How to perform the Asset Liability Modelling to determine Investment Strategy

-
Image
 How to perform the Asset Liability modelling to determine the investment strategy.   First, let’s understand Asset liability Modelling Actuary try to project company’s assets and liabilities into future and then check whether insurance company has sufficient assets to meet there liabilities or not. Along with that Actuary also checks whether the solvency position as required by regulator is satisfactory or not. Asset liability modelling is a tool to project assets proceeds and liability outgo into the future that can be used to help in setting investment strategy to control the risk of falling to meet an objective. Now question in your mind would be what is objective? For ex: Objective can be that assets should be more than liabilities for the next 10 years with 99.5% confidence interval. In Objective, we try to make it quantifiable along with time horizon and a defined probability interval. Assets Projection Now to project assets we have to see various types of asset cl
Read more

Components of Solvency II in a Layman Language - Phase 2 - Actuarial

-
Image
Now let’s understand these terminologies in a simple English. Assets: Assets are generally valued at market value which is easily available for the quoted securities. For the unquoted, we generally use fair or economic value i.e. the price at which assets can be exchanged or liability can be settled. Under Solvency I, they use book value i.e. original cost possibly with depreciation. There are various methods of valuing assets such as: o    Market value o    Fair value o    Discounted Cashflow approach o    Arbitrage approach o    Smoothed Market value o    Written down value Best Estimate Liability: First of all let’s understand what is best estimate ? So there are 3 strength of basis i.e. o    Optimistic – Here the assumptions are set in such a way that places higher value on assets and/or lower value on liabilities. It means my surplus will be higher, profit will be higher and thus taxes paid will be higher o    Prudent – Here the assumptions are set in such a wa
Read more