Derivatives: Forwards vs Futures

  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

How an Actuary establish the Investment Strategy for a company ?

The main aim of Actuary is to match assets with the liabilities. In case of insurance companies, actuary major role is to find the capital requirement. In a layman language, capital requirement means the amount that an insurance company has to set aside to ensure that they are able to meet the liabilities in the future with a given degree of confidence.

Therefore, the more risk company possess, more will be the capital requirement. Actuary try to reduce this risk by matching asset and liability.

Matching asset and liability: Let’ understand a simple example. Suppose you have to pay your friend Rs. 10,000 next year. So, today you can invest Rs.9500 in a Bank as a Fixed deposit that that can provide a return of 5.26% per annum. So you can use bank deposit money after one year that will be 10,000 to pay your friend 10,000. That’s how you match your liability outgo with your asset income and thus reduces the risk of being default. Same concept applies to insurance companies as well.

To establish an investment strategy, we have to consider a lot of points such as:

Characteristics of Liabilities:

·         If liabilities are real in nature, then we match with real assets such as equities, properties etc.

·         If liabilities are long term in nature (as in case of pension and life insurance), then we match with assets of long term nature i.e. long term bonds, equities etc.

Regulatory restrictions

·         Sometimes regulator describes which assets you cannot invest in or which assets should hold atleast minimum percentage in your portfolio. For ex,

o   Regulator can say that you cannot invest in derivatives as an insurance company because this asset class in too risky and there is a threat that you are not able to pay your liability to policyholders

o   Regulator can say that you have to invest atleast 35% of your portfolio assets into government bonds because these are risk free investment and it helps in reducing overall risk of the insurer and ultimately reduces the capital requirement.

Taxation: Different types of asset classes will have different taxes. For ex, investment in ELSS(Equity linked savings scheme) can help in getting tax deductions or some returns on asset classes can be considered as an income and capital gain will have different tax rates.

Expected return and risk: Every company has its own risk appetite (risk appetite means the maximum risk a company can take in order to achieve its objectives) so companies try to make a balance between risk and return of a particular asset before investing

Diversification: Suppose Company X has invested a lot of there assets in Domestic Large Cap Bank based equity, so more investment in same asset class will lead to decrease in diversification and increases the concentration risk. The more the risk, the more will be the capital requirement.

Competitors Strategy: Monitoring of competitor’s strategy plays a major role in own investment strategy

Financial position: If company X has a huge amount of assets and company Y has relatively less amount of assets. Then, technically X has a high risk appetite as compare to Y and they can invest in more risky assets to enhance returns

Follow us on Linkedin: Actuary Sense

Follow us on Instagram: Actuary Sense


Popular posts from this blog

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

How to perform the Asset Liability Modelling to determine Investment Strategy

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