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Ponzi Fraud, Market Turmoil, and Investment
Regulations
Ken SugitaSumitomo Mitsui Trust Bank
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Session Number: (WBR10)
The opinions expressed or implied in this paper is solely those of the author and do not necessarily represent the views of Sumitomo Mitsui Trust Bank.
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Agenda
Ponzi FraudMarket TurmoilConclusion
1
Terms
PensionsDefined Benefit Corporate Plans
Investment RegulationsQuantitative limits (vs Risk based)
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
What is a Ponzi scheme?
A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. The schemes are named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. http://www.sec.gov/answers/ponzi.htm 2
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Who is Bernie Madoff?
Bernard L. Madoff, who is currently serving a 150-year sentence in federal prison, orchestrated a multi-billion dollar Ponzi scheme that swindled money from thousands of investors. Unlike the promoters of many Ponzi schemes, Madoff did not promise spectacular short-term investment returns. Instead, his investors phony account statements showed moderate, but consistently positive returns even during turbulent market conditions.http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html
3
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Like a baseball player batting .966 for the season (Harry Markopolos)
‐1.00%
‐0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
1990 1995 2000 2005
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Monthly Returns of the Madoff Fund
4
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
How to evade or mitigate Ponzi Fraud Risk
Investment RegulationsQuantitative LimitsRisk Based
Due diligenceSimulationCalculation of RisksUse of Management Accounts
5
Cf .Basel II
Track Records
Fiona Stewart “Pension Fund Investment in Hedge Funds” OECD September,2007
Slovak Republic and Mexico (for the mandatory system) prevent pension funds from investing in hedge funds.Spain (under the new 2007 pension legislation),
Greece and Portugal have direct quantitative limits on pension fund investment in hedge funds are ‐ all at 5% (rising to 10% in Portugal for closed funds and open funds with collective membership).
Investment Regulations for Hedge Funds
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
6
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Basel II Pillar 1
Eligible capital / Risk Weighted Assets>=8%
Risk Weighted Assets (RWA)= RWA for Credit Risk+ RWA for Market Risk+ RWA for Operational RiskHedge funds ->RWA for Credit Risk
7
Basel II:Investment Funds under the Standardized ApproachWhen the asset composition of the fund can be “looked-
through”, the risk-weighted asset of each underlying asset is calculated and summed up.
When it is difficult to look-through the asset composition of the fund, the maximum risk weight of the underlying assets will be applied to the unknown portion of the underlying assets.
Claims on sovereigns (Rated AAA~AA-)= 0%-Claims on banks and corporates (Rated AAA~AA-)= 20%-Secured by residential property= 35%-Claims on banks and corporates (Rated A+~A-)= 50%-Claims on banks and corporates (Rated: BBB+~BB-)= 100%-Past due loans for more than 90 days(if specific provision are less than 20%,except
mortgage loans)= 150%-Securitisation exposures (Rated BB+~BB-: for investors) = 350%-Securitisation exposures (Unrated, subordinated portion)= Deducted from the
regulatory capitalJoint IACA, IAAHS and PBSS Colloquium in Hong Kong
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8
Basel II:Investment Funds under the IRB Approach
Possible to “look-through”? → “look-through” approach
Majority composed of equities ? → Adjusted Simple Majority Approach(300%~400%)
Mandate of the fund available? → Mandate approach
Market value of the fund available on a daily/weekly basis?
→ Internal Models(VaR)
High risk instruments excluded from the fund? → 400%
1250%
YES
NO
NO
NO
NO
YES
YES
YES
YES
NOJoint IACA, IAAHS and PBSS Colloquium in Hong Kong
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9
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Due Diligence
10
Assess:Viability and persistence potential of thetrading strategy which needs to remuneratethe risks taken;Sustainability of the operations supporting the trading strategy;Ability of the fund to operate as a firm and manage the associated challenges (growth, technology, retention of key personnel, etc.).
Simulation
TerminalPayoff
S&P Index
Ceilings from writing out‐of‐ the‐money call options
Floor from buying out‐of‐the‐moneyput options
Participations in the market
Carole Bernard & Phelim Boyle “Mr.Madoff’s Amazing Returns: An Analysis of the Split-Strike Conversion Strategy”
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
11
Calculation of Risks
12Joint IACA, IAAHS and PBSS Colloquium in Hong Kong
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An opaque fund A transparent fund
???
Value at Risk
IBM
Coca-Cala
Track Records
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Ordinary Hedge Funds
Trade TicketsMoney Management
Hedge Fund
Hedge FundManager
Investors
13
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Use of Managed Accounts
Reporting
Monitoring
Trade Tickets
IndependentAdministrative Agent
Hedge FundManager
Investors
Managed Account
14
How to cope with Market Turmoil
Investment RegulationsQuantitative LimitsRisk Based
MatchingDynamic HedgingUse of Volatility Index
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
15
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
0
50
100
150
200
250
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29
4%‐2%→10%→4%10%→‐2%→4%
Negative Returns & Medium Maturity
year
Pension assets
Rate of investment Return
cf. Kocken,Theo”Why the Design of Maturing Defined Benefit Plans Needs Rethinkin” Rotman International Journal of Pension Management Volume 4 Issue 1 Spring 2011 16
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
0
50
100
150
200
250
22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41
4%
‐2%→10%→4%
10%→‐2%→4%
Negative Returns & High MaturityPension assets
Rate of investment Return
year
17
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Turbulent Markets
0
200
400
600
800
1000
1200
1400
1600
1800
2000Jan‐70
Jan‐72
Jan‐74
Jan‐76
Jan‐78
Jan‐80
Jan‐82
Jan‐84
Jan‐86
Jan‐88
Jan‐90
Jan‐92
Jan‐94
Jan‐96
Jan‐98
Jan‐00
Jan‐02
Jan‐04
Jan‐06
Jan‐08
Jan‐10
Jan‐12
Nomura‐BPI
Topix
CGWBI
MSCI‐kokusai
18
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Investment Regulations and Performance
50%
20%
20%
10%
34%
28%
16%
22%DomesticBonds
Domestic Equities
Overseas Bonds
Overseas Equities
Fund A Fund B
In 1997,Japan abolished investment regulations called “5-3-3-2 regulation", which sets exposure of bonds over 50%, sets limit of equities up to 30%,overseas assets up to 30%,real estate up to 20%.
Cf.OECD”Survey of Investment Regulations OF Pension Funds” July,2008
19
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Comparison of assets
80.00
90.00
100.00
110.00
120.00
130.00
140.00
150.00
160.00
170.00
180.00
Jan‐97
Jan‐98
Jan‐99
Jan‐00
Jan‐01
Jan‐02
Jan‐03
Jan‐04
Jan‐05
Jan‐06
Jan‐07
Jan‐08
Jan‐09
Jan‐10
Jan‐11
Jan‐12
Fund A
Fund B
20
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Comparison of annual returns
‐40.00%
‐30.00%
‐20.00%
‐10.00%
0.00%
10.00%
20.00%
30.00%
Jan‐98
Jan‐99
Jan‐00
Jan‐01
Jan‐02
Jan‐03
Jan‐04
Jan‐05
Jan‐06
Jan‐07
Jan‐08
Jan‐09
Jan‐10
Jan‐11
Jan‐12
Fund A
Fund B
Return:1.88%STDEV:6.38%
Return:1.56%STDEV:10.43%
21
LiabilitiesBonds
Risky Assets
Matching
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
22
stockprice
profit
B
buy andhold
Abuyand
probability to sufferhedge loss
Dynamic Hedging
With hedge
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
23
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24
Assumptions of Dynamic HedgingDelta : Black-Scholes modelFloor: 15% below the price at the beginning of the year. Trigger : 7% below the beginning price(to replicate put options only in the market turmoil
situation)Permissible range : plus or minus 10%
(to avoid accumulated cost due to the frequent trade to replicate options with futures)
Investment time horizon: one yearFutures positions: liquidated at the end of each year.
×
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
50
60
70
80
90
100
110
120
130
140
150
00/3 00/10 01/4 01/10 02/4 02/10 03/4 03/10 04/4 04/10 05/4 05/10 06/4 06/10 07/4 07/10 08/4 08/10 09/4 09/10
×
Simulation of Dynamic Hedging
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10
Cf.Chuo Mitsui Asset Trust “Risk Control Strategies of Pension Investment”2010 (Japanese Language)
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
25
Volatility Index
The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility.
http://www.cboe.com/micro/VIX/vixintro.aspx26
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
VIX is often referred to as the “investor fear gauge”
0
10
20
30
40
50
60
70
80
90
Jan‐98 Jan‐99 Jan‐00 Jan‐01 Jan‐02 Jan‐03 Jan‐04 Jan‐05 Jan‐06 Jan‐07 Jan‐08 Jan‐09 Jan‐10 Jan‐11 Jan‐12
27Joint IACA, IAAHS and PBSS Colloquium in Hong Kong
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0
0.01
0.02
0.03
0.04
0.05
0.06
0 10 20 30 40 50 60 70 80
30 day standard deviation of future returns of S&P 500
10day average of VIX index
Data:1998.1.2‐2012.3.27
VIX and future volatility
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
28
0
50
100
150
200
250
300
350
400
450
500
Jan‐90
Jan‐91
Jan‐92
Jan‐93
Jan‐94
Jan‐95
Jan‐96
Jan‐97
Jan‐98
Jan‐99
Jan‐00
Jan‐01
Jan‐02
Jan‐03
Jan‐04
Jan‐05
Jan‐06
Jan‐07
Jan‐08
Jan‐09
Jan‐10
Jan‐11
Jan‐12
buy&hold
rebalance
S&P 500 Buy & hold vs. Rebalancing with VIX
Return:0.55%STDEV:4.40%
Return:0.37%STDEV:3.93%
29Joint IACA, IAAHS and PBSS Colloquium in Hong Kong
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VIX > 30 at the beginning of the month -> Sell the index fundVIX <= 30 at the beginning of the month-> Buy the index fund
0
200
400
600
800
1000
1200
Jan‐90
Jan‐91
Jan‐92
Jan‐93
Jan‐94
Jan‐95
Jan‐96
Jan‐97
Jan‐98
Jan‐99
Jan‐00
Jan‐01
Jan‐02
Jan‐03
Jan‐04
Jan‐05
Jan‐06
Jan‐07
Jan‐08
Jan‐09
Jan‐10
Jan‐11
Jan‐12
buy&hold
rebalance
Hang Seng Buy & hold vs. Rebalancing with VIX
Return:0.76%STDEV:7.61%
Return:0.48%STDEV:7.17%
30Joint IACA, IAAHS and PBSS Colloquium in Hong Kong
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0
20
40
60
80
100
120Jan‐90
Jan‐91
Jan‐92
Jan‐93
Jan‐94
Jan‐95
Jan‐96
Jan‐97
Jan‐98
Jan‐99
Jan‐00
Jan‐01
Jan‐02
Jan‐03
Jan‐04
Jan‐05
Jan‐06
Jan‐07
Jan‐08
Jan‐09
Jan‐10
Jan‐11
Jan‐12
buy & hold
rebalance
TOPIX(Tokyo Stock Exchange)Buy & hold vs. Rebalancing with VIX
Return:‐0.44%STDEV:5.81%
Return:‐0.43%STDEV:5.61%
31Joint IACA, IAAHS and PBSS Colloquium in Hong Kong
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Use of Daily data with holiday adjustmentsCombination with other economic indicators.
Conclusion
Ponzi FraudInvestment Regulations (cf.Basel II )Due Diligence, Simulation, Calculation of Risks,Use of Managed AccountsDo not rely too much on track records
Market TurmoilInvestment RegulationsMatching, Dynamic Hedging, Use of Volatility
Index32
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
Joint IACA, IAAHS and PBSS Colloquium in Hong Kongwww.actuaries.org/HongKong2012/
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