Market impact

Editor's letter

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Anyone who has bought or sold property (especially in London) will have sympathy for those who have to make large transactions in unfamiliar markets. There are three stages to the process.

First, one makes an extensive analysis of the market to determine the affordable solutions. Second, one enters the market (usually via an intermediary), often bringing a feeling of intense disappointment over the gap between theory and reality. Third, transaction completed, one sits back and reflects that the solution was in fact a very good one.

While it may be absurd to compare a modest outlay on bricks and mortar with complex billion-plus ALM or LDI transactions conducted by life and pensions providers, there is sufficient analogy in that changes in regulation and risk management across the industry are bringing many practitioners to the derivatives markets for the first time.

Market-consistent valuation is the first stage, where an unfamiliar market becomes the reference point for a new understanding of liabilities. Comparison with assets identifies a problem: a mismatch risk which does not reward stakeholders. Like the missing piece of a jigsaw puzzle, a derivatives asset such as a swaption or inflation swap can be found to fill the gap.

At this point, although intermediaries may be circling round, all is still theoretical. Then comes the choice to enter the market. In fact there are many choices: the kind of performance targets driving the transaction, and how the risks of execution are allocated within one's organisational structure; the kind of intermediary chosen, and the type of mandate they receive.

But like a foray into the property arena, once the choices are made, the market asserts itself. However carefully the mandates have been designed and the intermediaries chosen, there will be noise, and there may be market impact. If one monitors market movements afterwards, there might even be a moment of regret - could things have been better timed, or structured more cheaply?

But the third stage of the process really begins when one turns off the data feeds and spreadsheet macros, and reflects on the purpose behind the transaction. Solving a problem gives freedom to think: if one has bought or sold a house, one can think about starting a family or moving abroad.

If a subsidiary has been de-risked, one can start thinking about selling it. That is the real meaning of the phrase 'strategic hedge'. Alternatively, impressed with one's success, there might be the temptation to leave the macros running and make it one's focus to find value in the derivatives markets, which can be used to create new business. Whichever route is chosen, it remains a challenging journey that is not for the weak-hearted.

So while London dinner parties may resound with property war stories, one has to commend life and pensions practitioners who are willing to speak publicly about their market experiences, accounts which until recently have been all too rare. It is a core mission of Life & Pensions to publish such accounts, and regulators take a close interest in them. We hope our readership will continue to share them with us.

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