Zero coupon fixed income plus option

Policy loan amounts for variable rate policy loans that are not subject to guaranteed maximums should be projected as time zero cash flows. Projected cash flows should include cash flows arising from investment income taxes and tax timing differences that are projected under CALM Footnote 3. No other income tax cash flows should be included in the projection. Cash flows related to tax timing differences should not be re-projected to reflect the interest rate scenario being tested.

If an insurer uses dynamic assumptions e. Cash flows projected for expenses, and for benefit payments that are subject to cost-of-living adjustments should reflect the impact of inflation assumptions that vary consistently with each scenario. Inflation rates should bear the same relation to risk-free interest rates as assumed under the CALM valuation. For example, if an insurer generates inflation rates dynamically under CALM, the same generator should be used to derive inflation rates in the initial scenario and stress scenarios that are consistent with these scenarios.

The projection of cash flows for liabilities that are classified as investment contracts in the financial statements and that are not covered in a previous section depends on whether the contract holder has an option to redeem the investment. If the contract is not redeemable, the insurer should project the same cash flows as those used in the balance sheet valuation. In particular, the balance sheet value of deposit-type liabilities should be treated as a time zero cash flow.

For most products, only contractual cash flows are projected , without assuming reinvestments. Universal life UL is an exception as the contract continues after the end of any interest guarantee period inside the investment account.

CFA Tutorial: Fixed Income (Coupon Bond & Zero Coupon Bond)

It is therefore necessary to use a reinvestment assumption to generate a credited rate that is used to project best estimate cash flows for premiums, policy charges and benefits and expenses. Insurers should use Initial and stress Scenario Discount Rates qq. The credited rate should vary appropriately with the scenario that is being tested, including the initial scenario.

The relation between the restated credited rates for LICAT purposes and the LICAT discount rates under each scenario should be consistent and maintain the same relationship as exists between actual credited rates and the implied discount rates that are derived from the assets both fixed income and non-fixed income used to support the specific UL product under the CALM base scenario. Where the universal life contract has minimum interest guarantees, the effect of these guarantees must be reflected in the scenario that is being tested. If the performance of a universal life contract inside-account benefit is tied to the performance of specific assets and these assets are held by the insurer, then the cash flows on these assets and liabilities should be included with the cash flows of other index-linked RPT products q.

If matching assets are not held, then the cash flows should be projected using assumptions that are consistent with those used in the balance sheet valuation and then adjusted for the scenario being tested. Equity risk is the risk of economic loss due to potential changes in the prices of equity investments and their derivatives. This includes both the systematic and specific components of equity price fluctuation. Required capital for all investments classified as common equities including equity index securities, managed equity portfolios, income trusts, limited partnerships, and interests in joint ventures is calculated by applying a factor to the market value of the investment.

The base factor is increased by 5 percentage points i. If an increased factor is used for an equity holding that is a substantial investment, the amount to which the factor is applied should be net of the amount of associated goodwill and intangible assets deducted from Gross Tier 1 capital in section 2. Substantial investments in mutual fund entities that do not leverage their equity by borrowing in debt markets, and that do not otherwise leverage their investments, do not receive equity risk factors for substantial investments.

Instead, a capital charge on the assets of the mutual fund entity will apply based on the requirements of section 5. For example, the factors for substantial investments do not apply where the insurer has made a substantial investment in a mutual fund as part of a structured transaction that passes through the unaltered returns i.

The treatment of offsetting long and short positions in identical or closely correlated equities is described in section 5. Required capital for preferred shares depends on their ratings, and is calculated by applying the factors shown in the table below to their market values. Refer to appendix 5-A for the correspondence between the rating categories used in the following table and individual agency ratings, and to section 3. Insurers should calculate required capital based on the full exposure amount and underlying risk assumed under these transactions, irrespective of whether they are recognized or how they are reported on the balance sheet.

No additional capital is required under this section for hedges of index-linked liabilities that have been taken into account in the correlation factor calculation under section 5. Where an insurer has entered into transactions including short equity positions and purchased put options that:. Insurers should contact OSFI for details on the calculation for determining the capital requirement for these hedges.

The requirements in this section are distinct from the requirements for counterparty credit risk arising from off-balance sheet transactions. Transactions referred to in this section remain subject to the requirements for potential replacement cost as described in section 3. Required capital for a short position in any equity security or index that does not wholly or partially offset a long equity position is the same as that for a long position of the same magnitude.

Positions eligible for offset recognition and the corresponding treatment are described in section 5. Required capital for a futures or forward position in any security or index is the same as that for the equivalent spot position, and is reported as if the position were current. Required capital for a swap is the same as that for the series of future or forward transactions that replicates the swap.

The insurer reports an equity exposure in an amount equal to the total current market value of the equities underlying the futures contract. The following describes the methodology used to determine the required capital for both equity options that have been purchased and options that have been sold. This methodology may not be applied to equity options embedded in products sold to policyholders. The market risk required capital for policies containing an equity option component is calculated using the methodologies for index-linked RPT products q.

Chapter 7 , as appropriate. Required capital for an option or a combination of options in exactly the same underlying equity is determined by constructing a two-dimensional matrix of changes in the value of the option position under various market scenarios, using the same valuation model that is used for the financial statements. The first dimension of the matrix requires an insurer to evaluate the price of the option position over a range within the corresponding equity risk charge above and below the current value of the underlying stock or index, with at least seven observations including the current observation used to divide the range into equally spaced intervals.

Required capital for the option position is then equal to the largest decline in value calculated in the matrix. The application of this method and the precise manner in which the analysis is undertaken must be documented and made available to OSFI upon request Footnote 9.


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The balance sheet carrying amount of an equity- or index-linked note is decomposed into the sum of a fixed-income amount, equivalent to the present value of the minimum guaranteed payments under the note, and an amount representing the value of the option embedded within the note. The fixed-income portion of the note is classified as a debt exposure subject to a credit risk charge based on the rating and maturity of the note, and the residual amount is treated as an equity option.

The insurer uses the Black-Scholes option valuation model for financial reporting purposes. Required capital for a convertible bond is equal to the credit risk required capital for the bond's fixed-income component, plus the equity option requirement for the bond's embedded warrant. Required capital for the fixed-income component is equal to the bond's credit risk factor based on its rating and maturity multiplied by the present value of the minimum guaranteed payments under the bond. The required capital for the embedded warrant is calculated using the scenario table method q.

As a simplification, an insurer may classify the entire balance sheet value of the convertible bond as an equity exposure and calculate required capital for the bond by applying the market risk factor for equities to the bond's value. Equity positions backing indexed-linked policyholder liabilities for which a factor is calculated under section 5. Offsetting hedges of an equity position may only be recognized if the party providing the hedge is an eligible guarantor as defined in section 3.

Long and short positions in exactly the same underlying equity security or index may be considered to be offsetting so that an insurer is required to hold required capital only for the net position. Where the underlying securities or indices in a long and short position are not exactly the same but are closely correlated e. If an insurer has not held a short position over the entire period covered in the correlation factor calculation, but the security or index underlying the short position has quotations that have been published at least weekly for at least the past two years, the insurer may perform the calculation as if it had held the short position over the entire period.

However, returns for actively managed short positions may not be inferred for periods in which the positions were not actually held, and mutual funds that are actively managed externally may not be recognized as an offsetting short position in an inexact hedging relationship. Option hedges of an equity holding may only be recognized if the party providing the hedge is an eligible guarantor as defined in section 3. Option hedges of segregated fund guarantee risk may not be recognized in the segregated fund guarantee capital requirement without explicit approval from OSFI.

The form and amount of any such recognition will be specified by OSFI at the time of approval.

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Option hedges of segregated fund guarantee risk that receive recognition in the segregated fund guarantee required capital cannot be applied towards other equity risks. If an option's reference asset is exactly the same as that underlying an equity position held, an insurer may exclude the equity holding in calculating required capital for its equity exposures and instead consider the combined change in value of the equity position with the option in constructing the scenario table q. An insurer may then exclude the equity holding from its required capital for equity exposures and instead calculate the combined change in value of the equity position with the option in a scenario table q.

No additional adjustments need be made to the assumed changes in asset volatilities under the scenarios to account for asset mismatch. An insurer has a long position in a main equity index in a developed market, and also owns a call option and a put option on different indices that are closely correlated with the main index. The highest factor F over the previous four quarters between the reference index of the call option and the main index, calculated per section 5.

Note that for short option positions, the direction of the adjustment to account for correlation will be opposite to that of a long option position. Real estate market risk is the risk of economic loss due to changes in the amount and timing of cash flows from investment property, and holdings of other property, plant and equipment. The carrying amount of investment property is divided into two components: leases in force and the residual value of the property.

For leases in force, required capital is calculated for interest rate risk section 5. The exposure amount used to determine the credit risk requirement is the present value of the contractual lease cash flows, including projected reimbursements for operating expenses paid by the lessor, discounted using the Initial Scenario Discount Rates specified in section 5. The residual value of the investment property is defined as its balance sheet value at the reporting date minus the present value of the fixed cash flows that are contractually expected to be received as determined in section 5.

For owner-occupied property Footnote 10 , required capital is calculated as the difference, if positive, between either:. Required capital is determined on a property-by-property basis. The factor for investments in unleveraged mutual funds Footnote 11 , exchange traded funds, segregated funds and real estate investment trusts is a weighted average of the market and credit risk factors for the assets that the fund is permitted to invest in.

The weights and factors are calculated assuming that the fund first invests in the asset class attracting the highest capital requirement, to the maximum extent permitted in its prospectus or Annual Information Form where more current. The factor for the mutual fund is then the sum of the products of the weights and risk factors for the assumed investment allocation.

In the absence of specific limits to asset classes or if the fund is in violation of the limits stated in the prospectus, the entire fund is subject to the highest risk charge applicable to any security that the fund holds or is permitted to invest in. Funds employing leverage Footnote 12 are treated as equity investments, and receive the equity risk factor corresponding to the fund under section 5. The credit risk factors in section 3. All assets backing index-linked products must be segmented and included in the index-linked reporting form, and receive factors based on the historical correlation between weekly asset and liability returns in section 5.

The correlation factor calculation may be used for index-linked products, such as universal life policies, having the following characteristics:. The historical correlations and standard deviations must be calculated on a weekly basis, covering the previous week period. The returns on asset subgroups must be measured as the increase in their market values net of policyholder cash flows.

All-in-One Accounts

The factor F for the previous 52 weeks is required to be calculated each quarter. The charge is then equal to the highest of the four factors calculated over the previous four quarters. This factor is applied to the fair value at quarter-end of the assets in the asset subgroup. Instead of using policyholder funds in the calculations, an insurer may use cash surrender values or policy liabilities to measure the correlation.

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The basis used must be consistently applied in all periods. As a simplification, insurers may choose to apply the common equity risk factor from section 5. When a synthetic index investment strategy is used, there is some credit risk that is not borne directly by policyholders. This may include credit risk associated with fixed income securities and counterparty risk associated with derivatives that are purchased under the synthetic strategy. Insurers must hold credit risk required capital for these risks in addition to the index-linked requirements of this section.

For index-linked insurance policies that have a minimum death benefit guarantee, the requirement for segregated fund mortality guarantees must be applied.


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This requirement may be obtained using the methodology described in Chapter 7. Currency risk is the risk of economic loss due to changes in the amount and timing of cash flows arising from changes in currency exchange rates. Learn more about bonds Learn more about the benefits, key features and risk factors of investing in bonds. Bonds are credit notes issued by governments, corporations or other issuers to bondholders. As a bondholder, you are extending credit to these issuers and they are obligated to repay the redemption value of the bond upon maturity, as well as a rate of interest during the life of the bond.

There is also a wide selection of tenors or terms from which to choose. Asset class insight For more information in Fixed Income, as well as other asset classes, read our investment essentials here. Benefits of investing in bonds. Investing in bonds may improve your return than sitting on cash. Bonds deliver stable and predictable coupons as streams of income. Bonds also offer predictable repayment of principal at maturity. Bonds exhibit low correlation to other asset classes, hence the inclusion of bonds can bring relative stability to a portfolio. Bonds often demonstrate comparable performance against equities over time, however with a lower volatility!

The market price of a bond is affected by market interest rates, and perceived creditworthiness of the issuer. Potential for capital gain from price appreciation occurs when market interest rates fall or when perceived creditworthiness of the bond's issuer strengthens. Categories of bonds are mainly classified based on the nature of issuers - common categories known to HK investors include: a.

Government Bonds - e. Corporate Bonds - e. A bond's credit rating indicates its credit quality and is based on the issuer's financial ability to make regular interest payments and repay the loan in full at maturity. Credit rating agencies help to evaluate the creditworthiness of bonds. Investment grade and non-investment grade bonds. Moody's applies a numerical indicator 1, 2, and 3 in each generic rating.

Zero-Coupon Bond

For example, A1 is better than A2. Ratings affect a bond's yield. The lower the rating, the higher will be the yield as investors will need extra incentive to compensate for higher risk. Non-investment grade bonds, on the other hand, are of lower quality, and carry a higher risk of default. Fixed rate bond A bond that pays a fixed rate of interest over its life.

The variable coupon is reset regularly e. The spread is fixed when the bonds are issued. The variable coupon rate adjustment means that FRNs have relatively stable bond prices due to limited interest rate risk. FRNs provide capital preservation and higher income as interest rate rises. Zero coupon bonds Zero coupon bonds do not pay out any interest prior to maturity. These bonds are sold at a deep discount because all of the value occurs at maturity when the principal is returned to the investor.

The main benefit of zero coupon bonds is for saving for an objective on a specific date. The drawback of zero-coupon bonds is that they are more volatile than bonds that make regular interest payments. But interest rate movements do not matter if bonds are held to maturity. Key Features. Institutional Login. Log in to Wiley Online Library.

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