Ponzi Fraud, Market Turmoil, and Investment … Fraud, Market Turmoil, and Investment Regulations Ken Sugita Sumitomo Mitsui Trust Bank Joint IACA, IAAHS and PBSS Colloquium in Hong

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.


Agenda

Ponzi FraudMarket TurmoilConclusion

1

Terms

PensionsDefined Benefit Corporate Plans

Investment RegulationsQuantitative limits (vs Risk based)


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


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


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


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


6


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

www.actuaries.org/HongKong2012/

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


9


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”


11

Calculation of Risks

12Joint IACA, IAAHS and PBSS Colloquium in Hong Kong

www.actuaries.org/HongKong2012/Joint IACA, IAAHS and PBSS Colloquium in Hong Kong


An opaque fund A transparent fund

???

Value at Risk

IBM

Coca-Cala

Track Records


Ordinary Hedge Funds

Trade TicketsMoney Management

Hedge Fund

Hedge FundManager

Investors

13


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


15


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


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


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


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


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


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%


21

LiabilitiesBonds

Risky Assets

Matching


22

stockprice

profit

B

buy andhold

Abuyand

probability to sufferhedge loss

Dynamic Hedging

With hedge


23



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)


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



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




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


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






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






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%




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



Documents

Ponzi Fraud, Market Turmoil, and Investment … Fraud, Market Turmoil, and Investment Regulations Ken Sugita Sumitomo Mitsui Trust Bank Joint IACA, IAAHS and PBSS Colloquium in Hong