2011 Chicago Ebig MTG Phillips

Equity-Based Insurance Guarantees Conference
November 14-15, 2011

Chicago, IL
Managing Basis Risk

Peter Phillips
Managing
g g Basis Risk
Annuity Solutions Group
Aon Benfield Securities
Securities, Inc
Inc.
Peter M. Phillips
p
November 15,, 2011 11:15 am to 12:00 pm
Equity-Based Insurance Guarantees Conference
Chicago, IL
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Annuity Solutions Group | Aon Benfield Securities, Inc. | November 15, 2011
Agenda
Section 1
Introduction
Section 2
Fund Mapping
S ti 3
Section
M d li B
Modeling
Bond
dF
Fund
d Ri
Risk
k
Section 4
Basis Risk Slippages
Section 1: Introduction
Basis Risk is Important

It can play a key role in hedge program performance
In the second half of 2008 hedge breakage losses at four companies exceeded $1.5 Billion
according to J.P. Morgan*
For some of these companies a great deal of the hedge breakage in 2008 came from basis risk
between actual account value movements and the hedge instrument index movements
This basis risk issue hit large direct writers and small reinsurers
Interesting facts
One company lost close to 1B USD on this problem in less than a single year
Another company produced a graph showing their hedge program performance excluding
basis risk
Actively managed fund exposure was dialed down after 2008
There is a lot of good literature in Finance on the topic of basis risk
Roll, A Mean/Variance analysis of tracking error
Sharpe, Asset Allocation: Management Style and Performance Measurement
Famma & French, ICAPM
Grinold and Kahn, Active Portfolio Management
* Variable Annuity Market Trends, J.P.Morgan May 29 2009
Section 2: Fund Mapping

pp g
Fund Mapping
Definition
VA guarantees are written on a basket of underlying assets
The underlying assets are often actively managed mutual funds
end of day, and are not available in real-time
real time
Mutual fund NAV (Net Asset Value) are reported daily at the end-of-day,
NAV returns must be modeled in terms of returns in observable/investible market indices and there are two
distinct issues to consider:
1.
Approximating NAV in real-time (required for intra-day liability Greeks)

What is the current value of the underlying?
2.
Hedging liability Greeks using tradable instruments (e.g. index futures, total return swaps, etc.)
What are the optimal hedge ratios?
Fund Mapping
Model
Fund Mapping
Additional Modeling Considerations
Global funds
Bond funds
Dividends (fund dividends and index dividends)
Fund fees (MER)
Currency exposure and hedging
Data sampling frequency (high frequency, daily, monthly)
Sample Window Mechanics
Moving or fixed duration
Hold out sample size
Number of observations
y g weights
g
Time-varying
Index selection process
Multicollinearity
Confidence intervals for estimates
Trading instrument basis risk (cash index versus futures index return)
Ex-ante versus Ex-post tracking error
Fund Mapping
Qualitative Approach
stylemapping
Fund1
Fund2
Aggressive
Balanced
indexmapping
S&P500
x%
Russell2000 x%
EAFE
x%
x%
100%
S&P500
Russell2000
EAFE
x%
x%
x%
x%
100%
10
Fund Mapping
Quantitative
Approach
Example Multivariate Fund Mapping Data
10
11
Fund MappingMulticollinearity
Multicollinearity refers to the case when the predictor variables are
highly correlated
This is an acute problem with financial index time-series data
Multicollinearity can be seen in these plots of NAV, S&P 500 and
g y correlated and form a 1Russell 2000 returns. All three are highly
dimensional line in 3-dimensional space this is equivalent to
trying to fit a plane through a line, which would lead to an unstable
estimate
Regression on such data can lead to unstable and unintuitive
weight
g estimates. For example,
p it can lead to negative
g
weights.
g
Solutions require reducing dimensionality of the predictor set:
2
1.5
Feature reduction (eliminate one or more predictors)
Regularization (Ridge regression, LASSO)
NAV
Feature extraction (Principal Component Regression, Partial

L
Least
t Squares
S
Regression)
R
i )
1
0.5
0
-0.5
-1
-1.5
-2
2
-1
-2
RTY INDEX
-3
-2
-1.5
-1
-0.5
0.5
1.5
SPX INDEX
11
12
Fund MappingMulticollinearity Bond Fund Example

Vanguard Bond Fund NAV return modeled
using AA Corporate Zero Curve (using 15
different tenors)
Daily NAV return versus change in yields:
12
13

If we simply apply least-squares regression to the data without PCA (nave approach), the regression
coefficients on the 15 tenors are sporadic and counter-intuitive, even though the model has reasonably good fit
(in-sample R2 = 84%)
13
14

If we apply Principal Component Analysis to the yield curve data, we find that 98% of variance in
the curve is accounted for by the first three principal components. The 15-dimensional yield
curve may be reduce to 2 or 3 dimensions. These three principal components may interpreted
as the level, slope, and curvature of the yield curve*
Applying linear regression on the 3 principal components results in regression coefficients that all
have negative sign (intuitive) and are stable
* LITTERMAN, R. AND J. SCHEINKMAN (1991). Common factors affecting bond returns, Journal of Fixed Income, vol. 1, no. 1, pp. 54-6
14
15
Fund MappingMulticollinearity Conclusion

Deciding which market indices to use for modeling a given fund is a complex statistical problem. This problem
is called feature selection and in determines the number of type of hedging instruments that are selected
Correlation between market indices must be handled carefully and requires identifying underlying, uncorrelated
risk factor drivers. This problem is called feature extraction and it is necessary for obtaining stable and
sensible hedge ratios
Feature selection and extraction must be done jointly and should be guided by qualitative analysis of each
funds investment mandate
15
16
Fund MappingConfidence Intervals

Confidence intervals for regression parameters have several
applications, including selection of hedging instruments and basis risk
monitoring
If a Beta confidence interval for an index includes zero then it
makes sense to remove the index from the model
Confidence intervals for Betas are also useful for studying and
detecting time-varying Beta (change in Beta over time due to
market structure changes)
Classical linear regression theory assumes that the tracking errors
(residuals) are normally distributed
However in practice tracking errors are not normally distributed.
Tracking errors often exhibit fat tails and negative skew (can be seen
through formal statistical tests for normality or through Normal
Quantile-Quantile
Quantile
Quantile plots)
This means that the classical theory, which assumes normal
distribution of errors, may paint a different picture of the actual
tracking error risk one could face in practice.
16
17
Fund MappingConfidence Intervals - Bootstrap

Statistical bootstrapping can be used to obtain confidence
intervals of regression parameters without making assumptions
about the distribution of data*
Bootstrap is a resampling method that is simple and relatively
effective but can require significant computational infrastructure
The method essentially requires randomly sampling points from
the time-series and repeatedly re-running the regression, in
order to approximate the probability distribution of Beta
(regression coefficient)
95% confidence interval
* Efron, B.; Tibshirani, R. (1993). An Introduction to the Bootstrap.
17
18
Fund MappingModel Testing

In order to asses model performance correctly, the data must be split into a training
set (used to estimate the model parameters) and a test set (used to measure the
models performance)
Various cross-validation techniques
q
exist for splitting
p
g the data ((such as random
sampling), however for time-series data the training set should be data occurring
chronologically prior to the test set (i.e. use past data to predict the future)
Note that the training/test windows can be rolled through the data, to obtain a
better estimate of the models performance
18
19

Failure to use out-of-sample datasets will lead to overly optimistic tracking error
predictions and can lead to completely opposite conclusions when comparing
different models
Increasing error
Decreasing error
Model Complexity
19
20
20
21

Basic model testing
Data sampling frequency (high-frequency, daily, weekly, monthly, quarterly)
Training window size (1 year, 5 years, etc.)
In the example
p below,, we find that out-of-sample
p tracking
g error is p
persistently
y higher
g
than insample
In-sample tracking error suggests that longer training windows are better, while out-of-sample
tracking error points to the opposite conclusion (shorter training windows are better)
Out-of-sample tracking
errors based on 300-day
forward predictions
21
22
Fund MappingTime-Varying Beta

Critical questions when estimating Beta:
What amount of historical data should be used?
How often should the estimate be updated?
Like market volatility
volatility, correlation is a stochastic process and is related to the
underlying market returns
Market correlation structure can change rapidly and may cause systematic hedge
program losses if fund mapping weights are not updated
22
23
Fund MappingTime-Varying Beta

Possible methods for handling time-varying Beta:
Rolling window update
Revise fund weights every X days using T years of historical data
Trigger based update
Monitor regression parameters / correlation, update if estimates move outside of
confidence interval
Sequential update models
Kalman
K l
Filt
Filter, P
Particle
ti l Filt
Filter
Market Implied Beta
Betas can be also be obtained from option-implied correlation
Betas derived from Kernel regressions
g
Time-varying Beta has been studied extensively in the CAPM literature (see Campbell
Harvey 1991). Several researchers find the Kalman Filter outperforms other methods of
g Beta,, in terms of tracking
g error ((Root Mean Squared
q
Error)*
)
estimating
* Mergner, S. & Bulla, J. (2005), Time-varying beta risk of paneuropean industry portfolios: A comparison of alternative modeling techniques.
23
24
Fund MappingTime-Varying Beta Kalman Filter
24
25
Fund MappingTime-Varying Beta Example 1
TrackingError(outofsample,annualized)
Kalman
150day
300day
OLS
RMSE
7.40%
7.50%
7.60%
7.60%
#ofPoints 2,360 2,241 2,096 2,395
25
26
Fund MappingTime-Varying Beta Example 2
TrackingError(outofsample,annualized)
Kalman
150day
300day
OLS
RMSE
0.84%
9.90%
9.00%
3.60%
#ofPoints 2,365 2,246 2,096 2,395
26
27
Fund MappingModel Selection

Which type of model to use is a complex decision that has a material economic impact on
a hedging program
Model selection criteria to consider include
Model performance
p
Out-of-sample tracking error should be stable, in-sample error should be low
Different models should be tested (different combinations of indices, training
windows sizes, dynamical models, etc.)
Business process manageability
Dynamic models may be difficult to manage without sophisticated daily operations
controls, reporting and fail-safes
Static models may lose predictive power in the event of sudden structural
changes in the market
Hedging instruments
Choice of models and indices depends on availability of liquid hedging
instruments
Real-time data
Selected indices should be quoted in real-time
27
28
Section 3: Modeling
g Bond Funds
28
29
Consequences of using GBM as process for bond fund returns

Bond fund returns are highly dependent on long term interest rate levels
when interest rates increase bond prices decline
Experiment: explicitly link interest rate movements to bond fund price changes using a stochastic equity and
interest rate generator and price a European put Option when T= 30, _S=0.2, _r=0.01, moneyness = 140%
correlation=1
correlation=0
%Diff
correlation=1
Stochasticrates
BS
Stochasticrate
BS
PutPrice
1.7164
1.7164
0.00%
5.0269
5.0269
%Diff
0.00%
Stochasticrate
8.1371
8.1371
BS
%Diff
0.00%
Delta
0.0376
0.0360
4.13%
0.0602
0.0574
4.67%
0.0668
0.0632
5.30%
Rho
36.0957
35.0724
2.83%
72.8377
70.9825
2.55%
97.6541
95.3216
2.39%
Vega
44.5833
43.3457
2.78%
63.1159
63.0164
0.16%
70.7413
67.9621
3.93%
Gamma
0.0010
0.0009
6.82%
0.0011
0.0010
7.09%
0.0009
0.0009
7.59%
Naively using GBM to model bond fund returns may have the following unwelcomed consequences
Biased hedge ratios and larger hedge breakage numbers
Dealing with the issue in practice
Use a stochastic equity and interest rate models to model your risk
Consider using multi-factor interest rate models
Make careful adjustments to how you calculate your hedge program Greeks and to how you measure
hedge program performance
29
30
Modeling Bond Funds

Additional Modeling Considerations
The common procedure includes the following steps:

Simulate forward curves for each projection step based on a calibrated stochastic interest rates model,
such as HW1/2,
HW1/2 LMM or String model
Estimate the average bond duration based on liability cash flows
Compute the zero coupon bond yield rate with duration and duration+1 for each projection step t
The difference of yield rates between step t-1 and step t is the bond fund return
Other considerations:
Some companies layer in other stochastic processes like credit spreads and inflation to better model
bond fund return process
Many companies adjust how they calculate their Hedge program Greeks to capture the dynamics
b t
between
changes
h
iin iinterest
t
t rates
t and
db
bond
d ffund
d returns
t
Many companies also adjust their performance attribution model to reflect such assumptions and to
properly partition hedge program performance
30
31
Modeling Bond Funds

HW2F Approach
The Hull-White Two-Factor Model defines the short interest rate as:
r ( t ) ( t ) X ( t ) Y ( t ),
r ( 0 ) r0
Where the two factors X (t ) and Y (t ) are stochastic processes defined by the following linear SDEs under
the risk neutral measure:
dX aXdt dW1 (t ),
X ( 0) 0
dY bYdt dW2 (t ),
Y ( 0) 0
With a two dimensional wiener process with correlation
dW1 (t ) dW2 (t ) dt
From this short rate model, forward curves f (t , s, s 1) are able to generated at each time step t, where
s=1,2,T years.
31
32
Modeling Bond Funds

Compute Zero Coupon Bond Yield Rates
Assuming the average cash flow duration is D, define two bond yield rates at time t
Bond1 (t ) f (t , s, s 1)
s D
Bond 2 (t )
f (t , s, s 1)
s D 1
Then the bond fund return can be defined as the difference of two yields
bond (t ) Bond 2 (t 1) Bond 1 (t ) Mfee

Here Mfee is the maintenance fee for this bond fund and this logic need to be adjusted if using stub year.
32
33
Section 4: Quantifying
y g Slippages
pp g due to Basis Risk
33
34
Simulating Basis Risk in Hedge OverlayA Simple Model
Y 1~
r1 2 ~
r2
TE Y
12 12 22 22 2 1 2 12 . 1 . 2
4. Tracking
Error
1. R Squared
3. Volatility
Estimates
2.Correlation
dZ 1 (t ) dZ 2 (t ) dt
1. R Squared assumption is 92.67%

2. Simulated Correlation Estimate = Sqrt(R Squared)=Sqrt( 92.67%) = .9627
3. Account Value equity Vol assumption is 20% and the Cash Index Vol used for hedging simulation is 20%
4 Projected
4.
P j t dT
Tracking
ki E
Error = S
Sqrt[
t[ AV *(1-.Correlation
*(1 C
l ti 2)] = Sqrt[.20
S t[ 202 *(1-.9627
*(1 96272)] = 5.41%**
5 41%**
2
**Weighted average tracking error based on daily data from the top 5 US equity sub account funds according to VARDS
34
35
Quantifying the Impact of Basis RiskA Simple Model

The table below presents results on repeated hedging simulations of a 5 year put option with a strike 1000,
AV=1100, T=5, Q=0, sig=20%, r = 5% with a weekly rebalancing interval, and a correlation between the
account value and index returns of .9627, a tracking error of 4.5%, and a real world drift of 8%
Across 10,000 paths
Optn
Optn
Cost
Cost
Option
Cost
w/o Tracking Error
w 5.4% Tracking Error
Naked
681
Max
154
365
Min
55
-119
Mean
102
102
60
Std
Std/Option Cost
43
117
7.90%
41.86%
194.15%
Theoretical Option Cost
102
Note how the standard deviation of the cost of hedging with basis risk is 5 times higher than without basis risk
In the real world you have volatility of the fund, the volatility of index, and the correlation changing, whereas in
our simulation these three factors were fixed
It is also worth noting
noting, the underlying has a return volatility of 20% as previously mentioned
mentioned, while the option
position itself at time zero has a return volatility of 56%*
* Option return volatility=delta*(S/put value)*underlying return volatility
35
36
Simulated Impact of Basis Risk on CostA Simple Model
36
37
Simulated Impact of Basis Risk on SurplusA Simple Model

Simulated Surplus with no basis risk
6000
Count
4000
2000
0
-300
300
-200
200
-100
100
100
200
300
200
300
Surplus
Simulated Surplus with 5.4% Tracking Eror
6000
Count
4000
2000
0
-300
-200
-100
100
Surplus
With tracking error, even if you hedge properly in a laboratory setting, you could face very significant
gains or losses even AFTER hedging
37
38
Basis Risk
Conclusion
Basis Risk can have a dramatic impact on hedge program performance

Even with highly efficient hedging programs considerable residual risk remains due to the following
Gearing of the Liability position
Ex ante basis risk between hedged items and hedging instruments in the laboratory
Changing levels of correlation and absolute volatility in practice
Suggestions:
Monitor tracking error closely
Use index funds that can be hedged
Simulate hedging new product designs to better appreciated the impact basis risk has on hedge program
performance, and on capital and reserve levels
Implement more advanced fund mapping techniques

Develop, test and implement more complex models of basis risk inside of hedge program simulations
Move your hedge program Greeks calculations to after the NAVs have been updated from the market
close
38
39

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Equity-Based Insurance Guarantees Conference

November 14-15, 2011

Managing Basis Risk

Basis Risk Slippages

Basis Risk is Important

Section 2: Fund Mapping

Approximating NAV in real-time (required for intra-day liability Greeks)

Example Multivariate Fund Mapping Data

Feature reduction (eliminate one or more predictors)

Regularization (Ridge regression, LASSO)

Feature extraction (Principal Component Regression, Partial

Fund MappingMulticollinearity Bond Fund Example

Fund MappingMulticollinearity Bond Fund Example

Fund MappingMulticollinearity Bond Fund Example

Fund MappingMulticollinearity Conclusion

Fund MappingConfidence Intervals

Fund MappingConfidence Intervals - Bootstrap

95% confidence interval

* Efron, B.; Tibshirani, R. (1993). An Introduction to the Bootstrap.

Fund MappingModel Testing

Fund MappingModel Testing

Fund MappingModel Testing

Fund MappingModel Testing

Fund MappingTime-Varying Beta

Fund MappingTime-Varying Beta

Fund MappingTime-Varying Beta Kalman Filter

Fund MappingTime-Varying Beta Example 1

Fund MappingTime-Varying Beta Example 2

Fund MappingModel Selection

Consequences of using GBM as process for bond fund returns

Modeling Bond Funds

The common procedure includes the following steps:

Modeling Bond Funds

With a two dimensional wiener process with correlation

Modeling Bond Funds

bond (t ) Bond 2 (t 1) Bond 1 (t ) Mfee

Simulating Basis Risk in Hedge OverlayA Simple Model

1. R Squared assumption is 92.67%

Quantifying the Impact of Basis RiskA Simple Model

w/o Tracking Error

w 5.4% Tracking Error

Theoretical Option Cost

Simulated Impact of Basis Risk on CostA Simple Model

Simulated Impact of Basis Risk on SurplusA Simple Model

Basis Risk can have a dramatic impact on hedge program performance

Gearing of the Liability position

Use index funds that can be hedged

Implement more advanced fund mapping techniques

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