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Immediate Annuities
3
In Europe
Non-European
USA
2009 B&W Deloitte GmbH
qu i di As ty Pr se em t Y iu i el m s ds in
of
Illi
Illi
qu i di As ty Pr se em t Y iu i el m s ds in
Bond Gross Redemption Yield less expected default losses less illiquidity losses on forced sale less management expenses Expected Bond Return less cost of default risk capital less cost of liquidity capital less cost of expense capital less unexplained residual Liquid risk-free rate Yield (%)
6 2009 B&W Deloitte GmbH
qu i di As ty Pr se em t Y iu i el m s ds in
DIRECT METHODS 1. Cross-sectional Regression 2. Liquidity Demand models 3. Liquidity Rent Rates
Illi
INDIRECT METHODS 4. Spread less historic default losses 5. Spread less Merton implied spread 6. Spread less CDS spread
Liquidity renting
Liquidity Renting
Before: Insurer / Pension Fund After: Bank Insurer / Pension Fund
Bank
Illiquid Asset
Cash
Cash
Problem for the Bank: Must regularly refinance the illiquid asset at uncertain future cost of funds.
9
Problems for the Insurer: LIBOR may understate available cash return. Joint default risk of bank and illiquid asset.
2009 B&W Deloitte GmbH
Direct Historic Default Spread Historic Expense Spread Historic Illiquidity Spread
Unexplained Residual
Indirect
Note: An indirect estimate of default risk, after taking out illiquidity, would allocate most of the spread to defaults. Whatever you choose not to analyse explicitly gets the unexplained residual.
10 2009 B&W Deloitte GmbH
Estimating Default Losses Historic Spreads (UK 7-10 year) and Mertons Model
8% 7% 6% 5% 4% 3% 2% 1% 0% 06/98
11
AAA AA A BBB
Mertons model works in a liquid world of no transaction costs or other frictions. This is not a promising start for calibrating illiquidity premiums.
06/99
06/00
06/01
06/02
06/03
06/04
06/05
06/06
06/07
06/08
2009 B&W Deloitte GmbH
400 300
Actual
200 100 0
97
12
98
99
00
01
02
03
04
05
06
07
08
09
Estimate
13
CDS price reflects: writer is providing liquidity, writer might default. No good reason to suppose these two effects cancel.
14 2009 B&W Deloitte GmbH
Writer Defaults
qu i di As ty Pr se em t Y iu i el m s ds in
of
15
Illi
Base Estimate: Liquidity event #1 p.a 20% of assets sold Sale discount 5%
Clientele Effect Long term investors hold a high proportion of illiquid assets
Quantifying these elements forms the basis of a liquidity premium model, which analyses how the two elements of cost reduction are shared in a competitive market between bond issuers and different investor clienteles.
16
Optimal strategy
0.9% 0.8%
0.7%
Illiquidity Gain.
0.6%
0.5%
Low r equir ed
liquid i
ty
0.4%
0.3%
0.2%
High
0.1%
requ ired
liqui d
50%
ity
60% 70% 80% 90% 100%
17
qu i di As ty Pr se em t Y iu i el m s ds in
of
Illi
18
Po s
sib
le
pr
ox
19
Discount at Swap yields Replio = cash + swap Discount at government Replio = bond yields government bonds Discount at AA less spread Replio for credit risk = ??
20
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