Actuarial Skills in the Financial
Markets
Phil Kane – Director: Securitized Credit
Casualty Actuarial Society – Chicago, IL
November 2007
How do Investment Banks Organize Themselves?
Investment Banking
Markets
Advisory and Relationship
Management
Securities & Derivatives - Sales and
Trading
DCM
Valuations
Capital Structure Advice
ECM
Structuring
Security Transactions
Cat Bonds
Acquisition/Spin-Off Strategies
ALM – Hedging
Equity Research
Secondary Insurance Policy Transactions
XXX Securitizations
Credit Research
Risk Management
Portfolio Credit Derivative Transactions
and CDOs
CDOs as Credit Reinsurance?
•
•
Andrew event ≈ Subprime Mortgage event
Like Reinsurance, CDOs re-tranche risk portfolios to re-distribute it
different risk appetites
Catastrophe Risk Placement
CDO Tranching
Sleep Tight protection
Super Senior
Excess of Loss
Senior Mezz
Working Layer
Junior Mezz
Retention
First Loss
CDOs : An Actuarial Role?
•
Much like Actuaries at the forefront of driving reinsurance transaction
pricing and execution,
•
Structurers model and execute CDO transactions…
•
CDO pricing transparency recently questioned but limiting discussion to
Credit Derivative CDOs, pricing models have become widely accepted and
have actuarial analogues.
•
Risk premiums are typically arbitrage free; two way markets allow for the
assumption that spreads are the best measure of default risk
•
In addition, ratings models usually have similar engine to pricing models,
but rely on agency statistics rather than market inputs
Portfolio Credit Derivative Models
•
Default Risk ≈ Similar to insurance Event Risk
If event happens, loss; no event, no loss
•
Spread Risk ≠ Insurance Premium Risk
No Mark to Market for Insurance Premiums (yet….)
Simple default models are typically based on binomial models for defaults;
With correlations between 0 and 1, Gaussian Copulas have become standard model
In Credit, as in the markets as a whole, individual risks are NOT independent
Marked to Market Risk
•
Trading desk hold statistical reserves for counterparty risks, “gap” risks, and
model risks. These are typically monitored by Risk Management (analogue to
Reserving Actuaries).
•
Trading Desks though are also exposed to Marked to Market as well, for
example, basis risk on hedges: (using CDX example with recent levels:)
CDX Tranches
30-100% [8.25]bps running
15-30% [14.5]bps running
10-15% [32.5]bps running
CDX Index
[61]bps
7-10% [73]bps running
3-7% [213]bps running
0-3% [18.55]% running
= [75.9]bps running expected total
Expected Basis approximately of [15]bps; can move though, +/- 5bps
Summary
Many roles for dedicated Insurance Knowledge
Actuarial Skills are directly transferable to Insurance Related Investment
Banking.
Life Actuaries have been successful migrated to ALM, asset sales, and
securitization products.
In markets, Portfolio Credit Derivatives behave in a many ways like
Reinsurance
In addition, to transact in the Credit Derivative Markets, one must firmly
grasp Market to Market Risks as well.
But, in general the modeling skills of an actuary can be successfully used in
CDOs of all asset classes.
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