Business School

Heading 1

ACTL4303 AND ACTL5303

ASSET LIABILITY MANAGEMENT
Course Outline
Semester 2, 2015
Course Overview

Greg Vaughan

Course Coordinators
Greg Vaughan
Sessional Lecturer for the course
Email: gregory.vaughan@unsw.edu.au
Consultation hours: by appointment (Mondays 5-6pm)

Professor Michael Sherris

Telephone: 9385 2333
Email: m.sherris@unsw.edu.au
Consultation hours: by appointment (Mondays 4-5pm and Wednesdays
5-6pm)

Course Aims
1.
2.
3.
4.

To provide students with coverage of the Institute of Actuaries of Australia part II professional
syllabus.
To provide an understanding of the main features of investors, investment markets, investment
classes and investment theories.
To develop an understanding of asset liability models, their application to asset allocation
decisions and the investment management process.
To be able to assess asset liability models along with relevant applications to different types of
liabilities.

The course builds on prior courses in the actuarial program, in particular ACTL3004 Financial
Economics for Insurance and Superannuation for undergraduate students and ACTL5109
Financial Economics for Insurance and Superannuation for postgraduate students.
It is one of three UNSW courses that cover the Actuaries Institute Part II syllabus, with this course
covering the Part IIB Investment and Asset Modelling syllabus.
An exemption from the Institute of Actuaries of Australia Part II course is based on obtaining an
average of 75% in ACTL4001, ACTL4002 and ACTL4303 or ACTL5100, ACTL5200 and
ACTL5303.

Learning Outcomes
Describe and critically discuss the characteristics and behavior of different Investment types under
different economic conditions, understanding the relationship between risk and return and
recognizing risk factors which include issuer default, counterparty failure, systemic liquidity, the
collapse of speculative bubbles, shocks to the economic system and cyclical/structural changes.
Demonstrate an understanding of the methods used for valuation of the common forms of debt, equity,
property and derivative securities. In particular students should be aware of: the valuation
methods and principles, data requirements and sources, the implicit assumptions and limitations
of these models
Demonstrate an understanding of the application and limitations of the major economic and financial
theories relevant to investment, and be able to critically evaluate these theories including: the
efficient market hypothesis, the capital asset pricing model, multi-factor pricing models, theories
from behavioral finance
Construct, critically evaluate and apply asset models of a stochastic nature that are appropriate to the
management of liabilities, and be able to: define appropriate investment objectives based on the
liability profile of a fund, specify appropriate investment constraints, based on the liability profile of
a fund, identify the characteristics of different types of asset models.
Critically evaluate the appropriateness of an asset model for a given context.
Derive consistent asset assumptions for asset models, taking into account historical date, prevailing
industry expectations, contemporary investment literature, and other practical considerations such
as tax.
Apply asset assumptions, and the linkages contained within asset models, to real world situations.
Describe and critically evaluate different approaches to asset allocation.

Textbooks
The prescribed textbook for this course is:
Investments. Zvi Bodie, Alex Kane, and Alan Marcus
McGraw Hill, 2014 ISBN13: 978-0-07-786167-4
Many concepts in this text will have been covered by students in previous courses. The
text is used to emphasise the practical aspects of the topics in the context of the
Course Outcomes.

Other reference texts are:

Fitzherbert R (2004) Investment Principles for Actuaries, Institute of Actuaries of Australia
UAM (ACC) C Bellis, Richard Lyon, Stuart Klugman and John Shepherd,(2010),
Understanding Actuarial Management, Institute of Actuaries of Australia & Society of
Actuaries, Second Edition

Required Readings
Required Readings (to be provided on Course web site):
APRA Prudential Practice Guide (2013) Investment Governance
Scowcroft, A., and J. Sefton (2005), Understanding Momentum, Financial Analysts Journal, Vol 61
No. 2 pp 64-82
Phalippou, L (2008), Where is the Value Premium?, Financial Analysts Journal, Vol 64, No.2 pp 41-48
Baker, M., B. Bradley and R. Taliaferro, (2014) The Low Risk Anomaly: Decomposition into Micro and
Macro Effects, Financial Analysts Journal, Vol 70, No 2 pp 43-58
Clarke R, de Silva H & Thorley S (2002). Portfolio Constraints and the Fundamental Law of Active
Management Sep-Oct pp48-66
Sargen, N (2014) Facing the Reality of Bubble Risk, CFA Institute Magazine, July-August 2014 pp
22-24
Wilcox, S. (2012) Equity Valuation and Inflation: A review , The Research Foundation of CFA Institute
Gootkind, C.L. (2012) Fundamentals of Credit Analysis (from Petii, B.S., J.E.Pinto and W.L.Pirie,),
Fixed Income Analysis, CFA Institute)
Berekelar A, Kobor A, Tsumagari M (2006). The Sense and Nonsense of Risk Budgeting, Financial
Analysts Journal Sep-Oct pp63-75
Heffernan, M.J., (2013) Real Property In Australia, Ch 6 & 7.6

Required Readings
Required Readings (continued)
Grinold, R.C., K.F.Kroner and L.B.Siegel (2011) A Supply Model of the Equity Premium, The Research
Foundation of the CFA Institute
Dimson, E (2013) Rethinking the Equity Risk Premium (a summary), The Research Foundation of
CFA Institute
Maginn, J et al, Managing Investment Portfolios, Chapter 5
Perold, A., & Sharpe, W. (1988). Dynamic Strategies for Asset Allocation, Financial Analysts Journal,
Jan Feb pp 16-27.
Ahlgrim, K.C., S.P.DArcy and R.W.Gorvett, Modelling Financial Scenarios: A Framework for the
Actuarial Profession

Teaching and Learning Approach

Review text and reference material prior to class meeting
Lectures introduce and explain concepts in the student learning outcomes of the Course
Each lecture will provide an overview of the topics and will focus on explaining concepts
and issues along with applications and practical issues.
The role of the lecture is also to provide students with an opportunity to ask questions
and discuss the major aspects of the topic with other students.
Participate in class as required discussion and questions, answers to discussion issues
Development discussion skills

Doing well in this course

Develop an approach to understanding main concepts
Develop detailed understanding of theory
Integrate concepts
Read widely text and articles on web
Work consistently reading, reviewing, summarising

Moodle
Course uses Moodle
Material for course:
Course outline
Lecture slides
Assignment
Academic Research Papers of interest
Websites of interest
Discussion forum

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Assessment

Assessment Task

Weighting

Length

Due Date

Mid-Session Exam

15%

1 hour

Monday 8 September

Report

15%

4000 words

As in schedule

Final Exam

70%

2 hours

University Exam Period

Total

100%

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Course Structure
Date

Topic
Capital markets

28 July

Introduction and investment background

4 August

Risk, return and portfolio theory

11 August

Asset Pricing and Market Efficiency

18 August

Economic and financial theories.

25 August

Equity valuation and Portfolio Management

1 September

Interest Bearing Securities

8 September

Mid-Session Exam; Risk Management

15 September

Property, Infrastructure , absolute return assets

22 September

Capital Market Expectations and Asset Allocation

10

6 October

Asset Liability Models

11

13 October

Futures Options and Derivatives

12

20 October

Currency and International Diversification, Performance

measurement and attribution

13

27 October

No Lecture

Asset classes and

analysis

Investment
management process

Asset Liability Models

and Applications

12

Educational Development Unit

Education Development Unit
The Education Development Unit (EDU) is part of the Learning & Teaching Portfolio and provides free
and confidential learning support to students at the Australian School of Business, including:
Academic skills workshops
Consultation services for students with individual or small group learning needs
Printed and online study skills resources, such as referencing guides, report writing and exam
preparation resources
Subject specific support
Student support program

13

Occupational Health & Safety Student

Information
Inform your Lecturer/Tutor:
-

Of hazards ie wet floors, leaky ceiling, loose wires or trip hazards

Insufficient seating in lecture theatre/classroom

Of Bullying, discriminatory and anti-social behaviour

If an alarm sounds:
-

Immediately gather up your possessions

Move in an orderly fashion to the nearest exit

Follow directions of the building emergency team and security

Congregate a safe distance from the building

Do not re-enter the building unless instructed to do so

In the event of an accident or emergency, inform your lecturer/Tutor and/

or contact Security on 9385 6666

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Chapter 1 Overview
Role of nancial assets in the economy: Real
vs. nancial assets
Riskreturn trade-o and the ecient pricing
Financial crisis 2008
ConnecCons between the nancial system
and the real side of the economy
Lessons learned for evaluaCng systemic risk
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15 INVESTMENTS | BODIE, KANE, MARCUS

Real Assets vs. Financial Assets

Real Assets

Financial Assets

Determine the
Claims on real assets,
producCve capacity and
do not contribute
net income of the
directly to the
economy
producCve capacity of
the economy.
Examples: Land,
buildings, machines,
Examples: Stocks, bonds
knowledge used to
produce goods and
services

1-16

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INVESTMENTS | BODIE, KANE, MARCUS

Universal Bank Activities

Investment Banking

Commercial Banking

Underwrite new
Take deposits and make
securiCes issues
loans
Sell newly issued
securiCes to public in the
primary market
Investors trade previously
issued securiCes among
themselves in the
secondary markets
1-17

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INVESTMENTS | BODIE, KANE, MARCUS

Financial Markets and the Economy

The InformaConal Role

Capital ows to companies with best prospects

ConsumpCon Timing

Use securiCes to store wealth and transfer

consumpCon to the future

AllocaCon of Risk

Investors can select securiCes consistent with

their tastes for risk, which benets the rms that
need to raise capital as security can be sold for the
best possible price

1-18

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INVESTMENTS | BODIE, KANE, MARCUS

Financial Markets and the Economy

SeparaCon of Ownership and Management
Agency problems arise when managers start pursuing
their own interests instead of maximizing rm's value

Mechanisms to miCgate agency problems:

Tie managers' income to the success of the rm (stock
opCons)
Monitoring from the board of directors
Monitoring from the large outside investors and
security analysts
Takeover threat
1-19

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INVESTMENTS | BODIE, KANE, MARCUS

Corporate Governance
The framework of rules, relationships, systems and
processes within and by which authority is exercised
and controlled in corporations. - ASX
Bad investment decisions by companies can be made
within clean corporate governance structures.

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ASX Corporate Governance Principles

and Recommendations (2010)
if not, why not
ASX Listing Rule 4.10.3 companies make annual
disclosure of extent of compliance with Recommendations
Key elements include:
Independent Chair, not the CEO
Majority of board should be independent directors
Audit committee only non-executive directors with a
majority of independent directors

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The two strikes rule

Corporations Amendment Act 2011
Previously no consequences when a board ignored a
negative vote on a remuneration report
First strike when a companys remuneration report
receives 25% or more no vote on votes cast.
Second strike the following year will spill the board

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Continuous disclosure ASX Listing Rule 3.1

Companies required to disclose market sensitive
information to ASX immediately
Exemptions include incomplete proposal or
negotiation
If the ASX considers there is or is likely to be a false
market it may compel a company to clarify
Objective is to minimise insider trading and to
maintain confidence in the market

23

Why was the 2007-2009 downturn so severe?

A global financial crisis, not a normal country specific
business cycle downturn
Excessive debt accumulation poses greater systemic risks
than are apparent during a boom
Loose monetary policy stimulates growth unsustainably
Private sector borrowing binges inflate housing and stock
prices beyond sustainable levels
The economic contraction from a financial crisis is much
more severe and extended (avg 4 yrs) than from a
business cycle downturn, and recovery takes longer (avg
10 yrs) Reinhart and Rogoff

24

How the Second Great Contraction (2007-2009)

happened (1)
Global savings glut from Middle Eastern oil earnings,
Chinese trade surplus, high saving countries with aging
populations (Japan and Germany)
The US was a popular and willing creditor for these savings
This-Time-Is-Different Syndrome Fed Chairman Alan
Greenspan frequently argued financial innovations
(securitization) enabled risk to be managed better than
ever before.

25

How the Second Great Contraction (2007-2009)

happened (2)
There are some common precursors to severe financial crises
which the US shared with previous episodes (Spain 1977,
Norway 1987, Finland and Sweden 1991, Japan 1992)
Rising asset prices
Slowing real economic activity
Large current account deficits, capital inflows
Sustained debt buildup (public,private or both)
Financial liberalization
A country can move from moderate debt to high debt quickly if
it loses control of its current account and budget position
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How the Second Great Contraction (2007-2009)

happened (3)
Mortgage loans to sub-prime borrowers with low initial
interest rates moved from <10% to 20% of loan issuance
Securitisation of sub-prime debt fuelled the fire
The US financial sector grew from 4% of GDP in
mid-1970s to 8% of GDP in 2007.
Ratio of household debt to GDP was stable at around 80%
until 1993 before moving to 130% by mid 2006
In the decade to 2006 US house prices appreciated by 92%
in real terms, compared to 27% from 1890 to 1996.

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How the Second Great Contraction (2007-2009)

happened (4)
As Adjustable Rate Mortgages reset, borrowers struggled
to pay loans and could not refinance in soft market
Foreclosures weakened prices and equity in loans went
negative
In the US it was relatively easy for borrowers to walk away
from their loans
The originate to distribute model meant loans were not
well supervised as they soured
Mortgage Backed Securities (MBS), often a significant part
of Collaterised Debt Obligations (CDOs) lost value
The assets of the shadow banking system were impaired
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How the Second Great Contraction (2007-2009)

happened (5)
Impaired balance sheets drove more foreclosures, weaker
prices, more negative equity, more loan delinquency
Credit Default Swaps enabled risk to be moved and
intensified, overwhelming underwriters (AIG)
Aggregation of risk within MBS was, with the benefit of
hindsight, poorly modeled
Ratings agencies were conflicted in their optimistic rating of
MBS and CDOs (issuers paid them)
Party finally stopped when short term lenders to the
shadow banking system, got nervous (Lehman)
The GFC involved a failure of regulation (not in Australia)
to prevent a massive systemic vulnerability
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Why not in Australia?

Australias supervision of banks by APRA was
interventionist rather than laissez faire
the capacity to respond, if need be, to developments in the
future is virtually without peer Glenn Stevens RBA
Governor May 2008
Little government debt, budget in surplus, growing
economy, strong terms of trade
Room to move with monetary and fiscal stimulus
go early, go hard, go households Ken Henry, Treasury
secretary advice to government
Australias response to the GFC praised by the IMF
But our household debt is high
30

Australias aggregate debt level is not high but our household debt is

31

The world is finding it very difficult to deleverage.

Change in debt-to-GDP
percentage, 2007-14

Source: Haver Analytics ; national sources; McKinsey Global Institute analysis

32

33

How a leveraged economy recovers

Source: McKinsey 2012 Debt and deleveraging

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Chapter 2 Overview
Asset alloca6on Asset classes
Money markets vs. capital markets
Types of money market instruments
Capital market securiCes:
Bonds
Equity
DerivaCves

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35 INVESTMENTS | BODIE, KANE, MARCUS

Asset class structures

- International equities by country

MSCI All Country World Index (ACWI) June 2015

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Asset class structures

- Australia is a high payout market

Source: MSCI, S&P/ASX. Figures as at June 2015

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Asset class structures

- equities by sector

S&P/ASX 200 Market Cap is $1.45t (July 2015). MSCI ACWI Market Cap is US$38t.

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Other Topics

Trading in the Australian market

Regulatory environment
The Australian superannuation system
Taxation and dividend imputation

39

Capital Market - Equity

Ordinary (Equity) Shares
Limited liability
Residual claim
Return in the form of dividends & capital appreciation
Preference Shares
Fixed dividends (limited)
Priority over ordinary
May be cumulative, redeemable or convertible

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Primary Market
Primary Market
Initial Public Offerings
Seasoned New Issues
Types of Primary Market
Public Offering
Private Placement

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Private Placements
Private placement: sale to a limited number of sophisticated
investors not requiring the protection of registration
Dominated by institutions
For sophisticated and professional investors
Professional investor as per Financial Corporation Act 1974
(Commonwealth)

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Secondary Market
Secondary
Existing owner sells to another party
Issuing firm doesnt receive proceeds and is not
directly involved
Liquidity Centre
Base for movement of indices
Action and activity oriented

43

Markets and Market Structure

Auction Market
Convergence and execution
ASX is an example of Auction market
Require heavy and frequent trading
Its why listing requirements on ASX

44

Dark pools and lit markets

Dark pools are off exchange anonymous trading venues

Offered by brokers and exchanges (ASXs Centre Point)
These are alternatives to conventional lit markets
A large trade may be transacted in the dark without
having impact
Dark pools reduce liquidity of lit markets

45

Direct Market Access and algorithmic trading

Investment managers can by-pass brokers and deal
electronically directly to the exchange via Direct Market
Access
This would usually be to facilitate algorithmic trading,
where trades are driven by an intelligent program
The conventional objective is to systematically drip trades
into the market without causing market impact
When buying, a symptom of market impact would be an
increase in the sell side of the spread
High Frequency Trading is a mischievous subset of
algorithmic trading

46

Takeovers
Three approaches:
On market bid (rare). Cash only, unconditional so can get
stuck half way.
Off market. May be hostile, cash and scrip combination,
usually conditional on certain level of acceptance, can be
increased if contested by interloper.
Scheme of arrangement. Typically friendly, requires
shareholder (75% by value, 50%) by number and court
approval, cash and scrip combination, usually conditional
and may include corporate restructure.
The Takeovers Panel regulates takeover activity to ensure
takeover rules are observed
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Who regulates what (1)?

Australian Prudential Regulations Authority (APRA)
regulates banks, institutional superannuation funds, life
insurance companies and general insurance companies
Australian Securities and Investments Commission
(ASIC) regulates companies, investment managers and
brokers
The Australian Securities Exchange (ASX) administers
listing rules for companies and operating rules for brokers
The Australian Accounting Standards Board (AASB)
issues company accounting standards
The Auditing and Assurance Standards Board releases
auditing standards (eg GS007)
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Who regulates what (2)?

The Australian Competition and Consumer Commission
(ACCC) regulates competition across businesses, to
prohibit for example:
businesses acting in an unconscionable manner against
their customers and against other businesses
contracts, arrangements or understandings that are likely
to substantially lessen competition in a market
abuse of market power through predatory pricing aimed
at damaging competitors and reducing competition

49

Who regulates what (3)?

Significant national assets, including water, energy and
port infrastructure enjoy reduced competition
These assets are not free to set their own prices or
access terms and conditions
Instead these are overseen by either the ACCC or the
Australian Energy Regulator

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APRA and superannuation funds (1)

Superannuation Prudential Standard (SPS) 530
Investment Governance
Funds must formulate specific and measurable risk
and return objectives
Due diligence process for the selection of
investments
Appropriate measures to monitor performance
Review objectives and strategies on a periodic basis
Formulate a liquidity management plan

51

APRA and superannuation funds (2)

Superannuation Prudential Standard (SPS) 530
Formulating the investment strategy
Identify risk factors and associated sources of return
Identify how sources of return interact , the variability
of interactions and impact on overall diversification
Determine target exposures to these risk factors
Determine appropriate stress scenarios and
undertake stress testing
Determine asset allocation targets and ranges

52

APRA and life/general insurance investment

Prudential Standards LPS and GPS 114 specify
Capital Adequacy Asset Risk Charge stress tests.
Capital requirements are sensitive to the asset mix,
and reduced by any effective asset-liability matching.
High capital requirements can dilute the return on
equity for investors

53

Australian superannuation system

Compulsory saving via Superannuation Guarantee
Employers must contribute 9.5% of employees salary
moving to 10% by 2021 and 12% by 2025.
Employees can generally choose the fund in which
these contributions are invested.
Within the chosen fund members usually have
investment choice via a range of diversified portfolios
at different risk levels. In some cases members can
also construct portfolios at the individual asset level
(member direct)
Default choice must conform to MySuper simplicity

54

Australian superannuation
Assets of $2.05t at March 2015

55

56

Australian superannuation
Average Asset Allocation of MySuper Products March 2015

57

Taxation of superannuation investment

Income and short term net realised capital gains
(<12mths) are taxed at 15%
Long term net realised capital gains are taxed at 10%
Imputation credits are included in taxable income
then rebated
Pension assets are tax exempt and receive the full
benefit of imputation credits. (eg a $70 fully franked
dividend is worth $100)

58

Dividend Imputation (1)

The concept of dividend imputation is to remove the
effect of company tax, so that the only tax impost is
the investors own tax situation.
This is achieved by restoring the dividend to its precompany tax equivalent
The investors tax rate is then applied to that gross
income
The investor receives a credit against their tax liability
for the tax the company has already paid
This credit may exceed the tax liability creating an
additional benefit to the nominal dividend
59

Dividend Imputation (2)

A company makes a profit of $100, and pays
company tax at 30% leaving $70 for distribution as
dividend
A $30 imputation credit is attached to the $70
dividend in respect of the company tax paid
The superannuation fund pays 15% tax on the
aggregate of the dividend ($70) and the franking
credit ($30). Tax = 15%x($70 + $30) =$15
The superannuation fund receives a credit from the
tax office of $30 against that tax liability, with the net
effect that the superannuation fund receives $15
The dividend is worth $85 to the superannuation fund
60

Next week
Risk, return and portfolio theory
Bodie Chapter 5
Nominal and real rates of return
Risk premiums (spreadsheet example in 5.4)
Return distributions, risk measures and time horizon
Forecasting with arithmetic and geometric means
Study 5.7 carefully - Deviations from Normality and Risk
Measures

61

Next week
Risk, return and portfolio theory
Bodie Chapter 6
Risk, speculation versus fair game
Risk aversion and utility values
The capital allocation line and leverage
Study Section 6.5 Carefully Risk Tolerance and Asset
Allocation
Study Appendix A

62

Next week
Risk, return and portfolio theory
Bodie Chapter 7
Mathematics of diversification
Markowitz Portfolio Optimisation
Capital Allocation and the Separation Property
Study Appendix A

63

Next week
Risk, return and portfolio theory
Bodie Chapter 8
Single index model
Security Characteristic Line
Study 8.4 carefully

64

Thank you for your attention

Greg Vaughan
gregory.vaughan@unsw.edu.au
Michael Sherris
m.sherris@unsw.edu.au
School of Risk and Actuarial Studies
ARC Centre of Excellence in Population Ageing Research
University of New South Wales

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