Inflation Derivatives and LDI Solutions - Euromoney Conferences

Inflation Derivatives and LDI Solutions 

Mark Button 

Executive Director, Inflation-Linked Trading 

May 2009 

FOR CONFERENCE USE ONLY

Table of contents 

buttonma [printed: February 1, 2007 1:46 PM] [saved: February 5, 2007 1:06 PM] C:\Documents and Settings\buttonma\Local Settings\Temporary Internet Files\OLK1C4\Risk_Feb07_slides.ppt 

SECTION 1 Defined Benefit Outline 2 

SECTION 2 Overview of LDI 9 

SECTION 3 Sources of Inflation Exposure 13 

SECTION 4 Risk budgeting the current position 18 

SECTION 5 Structuring 22 

SECTION 6 Rich/Cheap – Exploiting dislocated markets 32 

SECTION 7 UBS Resources 36 

SECTION 8 UBS Inflation-Linked Strategy 43 

SECTION 9 Contact Details 49 

1

SECTION 1 

Defined Benefit Outline

uttonma [printed: February 1, 2007 1:46 PM] [saved: February 5, 2007 1:06 PM] C:\Documents and Settings\buttonma\Local Settings\Temporary Internet Files\OLK1C4\Risk_Feb07_slides.ppt 

Background To Defined Benefit (DB) Pension Schemes In UK 

Key facts and figures… 

Accrued Liabilities 

• Valued on accounting FRS17/IAS19 basis, liabilities are £850m * and on a true buyout 

cost basis (if the industry were to be re-insured) would be £1,356m * 

Assets 

• Valuation of £837m * , largely invested in equity type assets, schemes are effectively “paid” 

to hold none-matching assets 

Deficits 

• The Pension Protection Fund in the UK (equivalent to PBGC in US) estimates its own risk 

to be based on a deficit of £148bn * , but the full “buy-out” deficit is probably in excess of 

£500bn 

Inflation Linkage 

• The vast majority of liabilities have some inflation linkage, either UK RPI, capped Limited 

Price Indexation (LPI) or inferred through wage inflation. The £1trn UK insurance industry 

has, on the other hand, principally non-inflation linked guarantees 

*Based on figures from PPF Purple Book March 2008 and assuming that PPF covers 85% of UK liabilities 

3

What Is A Liability? 


A more difficult question than at first appears!... 

Minimum Funding 

Requirement 

♦ Old regulatory 

minimum 

♦ Relatively 

toothless 

standard, and 

superceded by 

new regime 

Transfer values Traditional 

actuarial 

valuation 

♦ Relevant if 

significant 

withdrawals 

♦ Transfer value 

bases likely to 

strengthen over 

time 

♦ Typically 

smoothed out 

market 

fluctuations by 

capitalising an 

equity risk 

premium that 

varied with 

market 

conditions 

PPF (Section 179) FRS17/IAS19 Gilts-matched Buy-out costs 

♦ Objective basis— 

uses risk-free 

yields less a 

deduction for 

risk, but based 

on a limited 

quantum of 

benefits 

♦ Corporate 

focus—and 

increasingly the 

benchmark in 

discussions with 

the Pensions 

Regulator 

♦ Increasingly 

relevant for 

closed 

schemes—and 

for pensions in 

payment 

♦ Includes margins 

for the insurers 

capital costs (and 

profit) 

♦ Can be triggered 

by certain 

corporate events 

4


Membership is skewed to pensioners & deferreds 

Fairly mature profile 

The breakdown by members is 25% active / 41% deferred / 33% pension. However 

deferred benefits will represent a smaller proportion by value. 

Pensioners, 

34% 

Breakdown of scheme membership 

Deferreds, 

41% 

Actives, 25% 

5


Typical Cashflows: A Cashflow Projection 

These are future values… 

Flow s, €m 

200 

180 

160 

140 

120 

100 

80 

60 

40 

20 

0 

Illustrative Liability Profile 

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 

Timing of flow (years) 

Actives 

Deferreds 

Pensioners 

6


DB Pension Scheme Asset Allocation 

Thinking behind historical weighting schemes… 

A long term funding approach 

• Paying for pensions was seen as an exercise in writing cheques from 

investment income and contributions, so short-term market volatility was 

irrelevant. 

Capturing the term premium 

• Equities seen as outperforming bonds with a very high degree of 

confidence over 20yrs+ holding periods relative to liabilities. 

Supportive valuation 

• The Actuarial valuation reduced the amount of “capital” pension schemes 

held against liabilities when equities were purchased for the scheme. 

Long dated liabilities 

• Liabilities were broadly duration roll neutral with an immature profile, 

containing significant amounts of wage indexation risk, which could be 

“matched” over the generational cycle with equities which would “hedge” 

inflation. 

7


Current Allocation Strategy Of DB Schemes 

High equity weightings in UK and Ireland… 

Allocation of funds in various European countries 

Netherlands 

Switzerland 

United Kingdom 

Source: Mercer 

Country 

France 

Germany 

Ireland 

Spain 

Equities (%) 

28 

31 

60 

33 

40 

22 

62 

Bonds (%) 

60 

56 

33 

63 

38 

52 

35 

Other (%) 

12 

13 

7 

4 

22 

15 

3 

8

SECTION 2 

Overview of “LDI”

Key Assumptions Typical To LDI 

Key underpinnings to LDI 

Liability Driven Investment (LDI) 


• LDI is the management of assets in a manner which is internally consistent 

with both risk appetite and projected liabilities 

Sponsor risk 

• Scheme valuation and ongoing risk management of the scheme must account 

for the fact that the sponsor has non-zero default risk 

Valuation 

• £1 of equities is worth £1 of bonds, no more no less, and switching assets 

does not reduce the value of liabilities 

Risk management 

• Liabilities are paid from either investment returns or contributions and risk 

management is concerned with the prudent management of these sources in 

the light of the estimated future cashflows 

10

Motivations of key “LDI” players 


Different institutions have divergent needs 

Insurance companies doing individual annuities 

Regular annuity books. Need yield and nominal matching. 

Insurance “back book” trades may incur reshuffles 

Asset Manager “strategic solutions” pooled funds 

LDI was sometimes sold as “put it to bed” and “hit the beach”. 

Enhanced Libor funds held illiquid ABS, Swap c/p not durable, Collateral?, Replacement? 

Self-administered & large DB pension schemes 

Sophisticated, will receive when swap valuations are more attractive & real yield levels improve 

Looking for real assets embedding inflation + spread (NR, Ground rents, leases, private placements) 

Pension buyout ante-chamber, or M&A candidate 

Equity, credit-spread and real rate sensitive, transition to hedged position 

Pension “buy-in” players 

RPI matching is a regulatory requirement 

Pricing basis predicated on credit investment. Volumes up if spreads stay wide. 

11


Moving From Traditional Thinking To LDI 

Traditional Thinking 

Funding Volatility Asset Values Liability Values Risk Management Asset Choice 

Pensions must 

be paid over 

time and they 

will be paid 

from income 

and 

contributions as 

they arise 

LDI Thinking 

I can capture 

the upside from 

risky assets as I 

am a long-term 

investor and all 

volatility is 

therefore 

inherently good 

My actuary 

computes asset 

values from 

long-term 

dividend yield 

assumptions, 

market values 

are of little 

relevance 

My liabilities are 

actuarial best 

estimates and 

have a 

reference 

“present value” 

based on my 

long term asset 

assumptions 

Risk arises in 

my actuary’s 

long-term 

assumptions 

proving to be 

wrong or that 

my sponsor 

does not 

contribute when 

expected 

I can capitalise 

upfront the 

equity risk 

premium and it 

would be 

difficult to sell 

non-equity 

asset classes to 

me 

Funding Volatility Asset Values Liability Values Risk Management Asset Choice 

I must be able 

to demonstrate 

my ability to pay 

pensions at all 

time and my 

funded position 

provides an 

indication of this 

ability 

Volatility in 

either my 

assets or my 

liabilities 

directly impacts 

upon the 

volatility of my 

funded level 

and this is risk 

management 

Asset values 

are the price 

someone would 

pay me for 

them and as 

such must be 

linked to market 

values 

Liabilities do not 

change with 

assets and are 

discounted 

using market 

term premia, 

given a degree 

of payment 

certainty 

Risk 

management is 

focussed on the 

management of 

assets relative 

to the liabilities 

which I must 

pay and markto-market 

Volatile assets, 

uncorrelated 

with liabilities 

are risky, but 

can be held as 

long as the 

“capital” 

implications are 

understood 

12

SECTION 3 

Sources of inflation exposure


Is the defined benefit liability inflation-linked? 

Complex, path-dependent inflation-linkage 

Active benefits 

– Salary-linked accrual until leaving date 

– Average-earnings linkage 

Pre-retirement Post-retirement 

Deferred benefits 

– Cumulative LPI (0,5) 

– Cumulative LPI (0,2.5) post ’08 accrual 

– GMP floor @ fixed or NAE 

Different inflation linkages apply at each stage of the pension arrangement 

Benefits accrued in different epochs are treated differently 

Pensioner benefits 

– Tax-free cash at retirement, PLUS 

– LPI (0,5) y/y on post-97 accrual 

– Full RPI in some scheme rules 

– Discretionary RPI common 

– LPI (0,2.5) accrual post-05 

– LPI (0,3) 88-97 GMP accrual 

– Some fixed increases 

14


Estimated liability profile for UK PLC 

We chart below a rough estimate of the liability cashflow profile for UK PLC. 

Annual flows, £bn 

45 

40 

35 

30 

25 

20 

15 

10 

5 

0 

Projected benefits at 2.5% inflation 

0 10 20 30 40 50 60 70 80 

Term in years 

Actives 

Deferred 

Pensioners 

15

Estimating a single-period hedge 


We estimate the cashflows under a range of inflation outlooks 

£ flows, bn 

140 

120 

100 

- 

80 

60 

40 

20 

Annual cashflow projections 

(by inflation assumption) 

0 10 20 30 40 50 60 70 80 

Horizon, yrs 

0.0% 

2.5% 

5.0% 

7.5% 

10.0% 

16


Building a full replicating portfolio for UK PLC 

We discover a high proportion of LPI-linked benefits 

Current hedge face amount, £bn 

- 

30 

25 

20 

15 

10 

5 

Replicating portfolio for benefits 

Fixed 

RPI 

0 5 10 15 20 25 30 35 40 45 50 55 60 

Horizon 

LPI 

17

SECTION 4 

Risk budgeting the current position

Comparing assets with liabilities 


We input the average asset allocation, and an approximate LDI benchmark 

Portfolio wt 

70% 

60% 

50% 

40% 

30% 

20% 

10% 

0% 

60% 

0% 

20% 

Equity IRSZ 

10yr 

30% 

12% 12% 

IRSZ 

20yr 

Asset and Liabilities 

5% 

25% 

IRSZ 

30yr 

15% 

0% 0% 

IRSZ 

40yr 

10% 

IRSZ 

50yr 

20% 

6% 6% 

RPIZ 

10y 

30% 

RPIZ 

20y 

25% 

3% 

RPIZ 

30y 

Assets 

LDI 

15% 

0% 0% 

RPIZ 

40y 

10% 

RPIZ 

50y 

19

Risk Exposures 


We compute the asset / liability mismatches 

Portfolio wt 

80% 

60% 

40% 

20% 

0% 

-20% 

-40% 

60% 

-8% 

Equity IRSZ 

10yr 

Asset / Liability Mismatch 

-18% -20% -15% -10% -14% 

IRSZ 

20yr 

IRSZ 

30yr 

IRSZ 

40yr 

IRSZ 

50yr 

RPIZ 

10y 

-24% -23% 

RPIZ 

20y 

RPIZ 

30y 

-15% -10% 

RPIZ 

40y 

RPIZ 

50y 

20


Compute 99.5% loss estimate using historic risk model 

Total risk budget is 32% of fund (or £220bn hit) 

We decompose the risk budget into contributions arising from each 

source 

Loss components 

40% 

35% 

30% 

25% 

20% 

15% 

10% 

5% 

0% 

14.6% 

Equity 

20.5% 

Liabs 

Risk budget decomposition 

0.5% 1.4% 0.8% 0.0% 0.0% 0.1% 0.2% 0.1% 0.0% 0.0% 

IRSZ 10yr 

IRSZ 20yr 

IRSZ 30yr 

IRSZ 40yr 

IRSZ 50yr 

RPIZ 10y 

RPIZ 20y 

RPIZ 30y 

RPIZ 40y 

RPIZ 50y 

32.0% 

Total 

21

SECTION 5 

Structuring


Who is using Inflation Swaps and Why? 

♦ Pension Funds 

♦ Simple structures to hedge complex liabilities. LDI. 

♦ Explicit inflation-linked pensions. 

♦ Infrastructure/Leaseholders 

♦ Toll roads. Leases linked to inflation. 

♦ Retail Banks 

♦ Retail notes linked to inflation. Hybrid structures. 

♦ Utilities 

♦ Water rates. Regulated services. 

♦ Asset Managers 

♦ Diversification. Outright views. Extra liquidity. 

♦ Hedge Funds/Prop Desks 

♦ Outright views. Asset Swaps. Exploiting mis-pricings. 

23


Direction of Inflation-Indexed Cash-Flows 

Pension Inflation Swap 

Swapped New IL Issue 

Investor unwinds 

IL ASW 

ZC Inflation 

Swap 

Securitization 

Lease/Rents 

Corp./PPP 

New Issue 

Investor buys 

IL ASW 

ZC Inflation 

Swap 

24

Sourcing Inflation Flows 


Corporate/Government issuance can/could(!) be translated into inflation swap 

flows through an asset swap investor 

Pension Fund 

Libor 

Real coupons + 

redemption uplift 

United Utilities 

UU IL 2056 

UBS 

Any profile or 

maturity 

mismatches 

Real coupons + 

redemption uplift 

UU IL 2056 

Libor + X 

Asset Swap 

investor 

25


Some Of The Reasons For Using Swaps 

The principle reasons for employing interest rate or inflation swaps 

• Ultra-long profiles 

Funds can transact in swaps where there are no suitable bonds 

• Deferred cashflow profiles 

Reinvestment risk can only be avoided by means of swaps 

• Cashflow mismatching risks can be eliminated 

Freeing up risk capital to be used in other “growth” areas 

• Inflation-linked profiles 

Provides closer matching than linkers 

• Liquidity for large transactions 

No physical supply shortages 

• Consultants can specify more efficient benchmarks 

Swap overlays used to augment the duration to the liability target 

26


Combining IRS with Inflation Swaps 

Combinations translates inflation risk to a floating rate 

Pensioners 

Inflation 

linked 

pensions 

Cash 

£100m 

Fixed 

interest 

rate [3%] 

UBS 

Fixed interest 

rate 

[5%] 

Fund UBS 

Deposit Account 

Inflation over 

the period 

Variable 

interest rate 

Variable 

interest rate 

27



Combinations translates inflation risk to a floating rate 

Pensioners 

Inflation 

linked 

pensions 

Cash 

£100m 

Fixed 

interest 

rate [3%] 

UBS 

Fixed interest 

rate 

[5%] 

Fund UBS 

Diversified Beta 

and Alpha 

Strategies 

Inflation over 

the period 

Variable decorrelated 

returns 

Variable 

interest rate 

28

Potential Hedge Ideas 


Making the best of a low rate environment… 

• Real rates 

Crossing Linkers with swaps to pick up the Real Swap Spread and offsetting 

transaction costs in size 

Hedging nearer term liabilities, avoiding hedging where forward re-investment are low 

Option strategies 

Purchasing options on Linkers over a short term horizon as protection against 

short-term fall in yields 

Selling option on real forward rates to generate income for the fund, monetising 

recent levels of high volatility 

• Break-Evens 

Using inflation swaps to reduce or eliminate break-even risk and to swap the liability 

back to fixed 

Swap back the fixed liability to floating when nominal rates are higher (possibly looking 

to protect the fund using receiver swaptions) 

Options on inflation swaps (eg selling an option to pay inflation as a tactical play – 

generating extra income for the fund) 

29



Close out inflation today & then de-risk duration post mean reversion… 

Initial position 

is short real 

yield 

Decreasing VaR 

Pension fund 

suffers when 

real yields fall 

Pension fund 

swaps back to 

fixed 

Fund now has 

short duration 

position 

Protection of 

downside with 

swaptions 

Hedges the fall in 

rates, benefits 

from rises 

Pension fund 

swaps back to 

floating 

Fund uses 

LIBOR 

products 

30

The big ALM shock in 2008 


Comprehensive capital losses and increased volatility 

Severe losses have been experienced in equity and credit markets 

Confidence in financial system, and ultimately stability of capitalism, has been eroded 

Long-term promises increasingly seem to require Governmental backstopping 

Stress tests will rise, but true “1-in-200 year” Solvency 2 tests are untenable 

Impossible to earn an attractive private sector ROE on egregious capital demands 

Options offer cheaper contingent capital than tapping sceptical equity investors 

Investment will simplify further 

This implies lower risk, lower leverage and simpler products for the majority 

Renaissance of capital-protected products, backed by options 

Credit becomes “buy & hold”, over-collateralised funding notes restore confidence 

Nimbler risk-management actions are required 

Focus on liquid markets for trading strategies 

Focus on gamma and vega management via options / volatility products 

Alpha / beta distinction undermined in murky asset classes 

31

SECTION 6 

Rich/Cheap: Exploiting dislocated markets


ILG BEI vs RPI Swaps – COB 7 May 09 

Bps 

% 

100.00 

80.00 

60.00 

40.00 

20.00 

0.00 

-20.00 

-40.00 

-60.00 

4.00 

3.50 

3.00 

2.50 

2.00 

1.50 

1.00 

0.50 

0.00 

RPI Swaps ILG BEI 

0 10 20 30 40 50 60 

Rich/Cheap 

3 4 5 6 7 8 9 10 12 15 20 25 30 40 50 

33


Proceeds Asset Swap Quotes – COB 7 May 09 

60 

50 

40 

30 

20 

10 

0 

UKIL11 

UKIL13 

UKIL16 

ASW Margin 

UKIL17 

UKIL20 

UKIL22 

UKIL24 

UKIL27 

UKIL30 

UKIL32 

UKIL35 

UKIL37 

UKIL47 

UKIL55 

34


Historical Asset Swap Spreads (2006 – 09) 

200 

150 

100 

-100 

150 

100 

50 

-50 

50 

0 

-50 

-100 

-150 

IL11ASW 

IL11 IL20 

24-Mar-06 10-Oct-06 28-Apr-07 14-Nov-07 1-Jun-08 18-Dec-08 6-Jul-09 

IL35ASW 

IL35 

0 


120 

100 

80 

60 

40 

20 

0 


-20 

-40 

-60 

-80 

150 

100 

50 

-50 

-100 

IL20ASW 

IL55ASW 

IL55 

0 


35

SECTION 7 

UBS Resources


UBS Delta: Award-winning, Industry-acclaimed 

“ 

Voted No.1 Electronic platform 

, 2008. 

“ 

Euromoney Credit Research Poll 

By harnessing internal and external creativity, developing an architecture that can bring resources together to 

solve problems from end to end, and providing the investment necessary to keep pace with the market and 

client requirements, UBS has created a system that is now at the forefront of the fixed-income and structured 

products markets. 

Risk Awards, 2007 

” 

“ Voted No.1 Electronic platform 

, 2007. 

Euromoney Fixed Income Research Poll 

” 

“ 

Best in-house developed or 

proprietary technology – UBS Delta. 

Buy-Side Technology Awards, 2007 

” 

” 

37


Functionality - Liability Driven Investment Solutions 

Asset portfolio objectives 

The UBS Delta optimization process supports a rich regime of constraints to reflect strategy, views, limits and market liquidity 

Liability projections 

Client-defined liability streams can be associated with 

Government, LIBOR, inflation index or credit curves 

Cashflow matching optimization 

UBS Delta can help minimize market revaluation risk 

and achieve no deficit funding, maintaining a net surplus cashflow as it accumulates and is re-invested over time. 

Risk analysis and swap overlay 

Clients are able to analyze deltas and track risk 

Bespoke regulatory reporting 

mismatches vs. any BM or liability stream. 

UBS Delta can provide client-specific actuarial reports 

that can be customized to cover, e.g., SST 

38


Sample market data available within UBS Delta 

39


40


41


Inflation-Linked Book: “The Leading Reference” 

♦Mark Deacon, Andrew Derry, and 

Dariush Mirfendereski (2004). 

“Inflation-Indexed Securities: Bonds, 

Swaps, and Other Derivatives” 2 nd 

Ed. 

Publisher: Wiley Finance January 

2004 

42

SECTION 8 

UBS Inflation-Linked Strategy

UBS inflation-linked strategy 

The Real Deal 

♦Our flagship WEEKLY publication 

♦Covering the main ILB markets 

♦Key views and themes updated 

♦Trade-idea focused (history included) 

♦Coverage of upcoming auctions 

♦Also include articles from… 

♦…UBS Economics teams… 

♦…other UBS strategy groups 


Screen-shot of a recent ‘The Real Deal’ 

44


Linker Headlines 

♦Rapid-response publication 

♦Focusing on important near-term issues 

that cannot wait for the weekly 

♦Covers upcoming auctions 

♦Changes to UBS inflation profiles 

♦We also highlight important research for 

IL markets, for example: 

♦Updates from UBS oil analyst 

♦Updates from EM Strategy 

♦Relevant research from UBS 

Economists 


Screen-shot of a recent ‘Linker Headlines’ 

45


Quarterly Inflation-Linked Themes 

♦Our flagship quarterly publication 

♦Giving our views on each market 

♦Thematic approach 

♦Considering important issues 

♦Includes ‘The Replay’… 

♦…a look back to all over the previous 

quarter’s publications, highlighting any 

important or relevant articles 


Screen-shot of a recent ‘QuILT’ 

46


Reality Bites 

♦Thematic research on a specific topic 

♦In-depth analysis, but presented in ‘bitesize’ 

format 


Screen-shot of a recent ‘Reality Bites’ 

47


UILR 


UILR to reach the UBS Inflation-Linked Strategy page on Bloomberg 

Source: Bloomberg 

48

SECTION 9 

Contact Information

Contact Information 

UBS AG 

100 Liverpool Street 

London 

EC2M 2RH 

United Kingdom 

UBS Investment Bank is a business group of UBS AG 


Mark Button 

Executive Director, 

Inflation-Linked Trading 

Tel: +44 20 7567 4438 

mark.button@ubs.com 

Inflation Trading Desk: 

John Baker, Andrew Barnet, Mark 

Button, Antonio Giampaolo, Pierre 

Lalanne, Dariush Mirfendereski, Adam 

Pasztor 

Tel: +44 20 7567 3311 

DL-InflationDesk@ubs.com 

50

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Inflation Derivatives and LDI Solutions - Euromoney Conferences

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