The presentation of the totally independent review committee on ERM valuation is sold out. The final research report (by Kent University) will be uploaded about a week beforehand (i.e. around Thursday 21 Febuary), so watch that space.
The launch event will bring together a multidisciplinary group of professionals to discuss Professor Tunaru’s findings. Due to the high profile nature of this research topic the launch event is expected to attract a high number of attendees and spark a topical debate, so early registration is advised.
By coincidence I noticed the 11 December presentation by the same committee is available on YouTube.
There is a about an hour and a half of it. The most interesting part is at 1:15:15 where David Land (Rothesay) questions why, despite much discussion of option pricing, they haven’t fixed the right method of calculating the forward. ‘That seemed like a pretty major source of possible error.’ Quite. He gives the interview question example of deferred possession of a house for one year. The candidates who say house price growth has anything to do with it don’t get the job!
My transcript is below. Golding replies by saying that it depends on whether you are modelling the cashflows or not. I didn’t quite see how that was relevant, given that the interview question involves cashflows too. He then suggests that the difference occurs when you move from the interview example of 1 year, out to 30 years, without explaining why the time period would make a difference.
Finally, Golding says he doesn’t know the answer.
Paul Fulcher says that the interview question is not about ‘the way the Matching Adjustment works’. I experienced this objection frequently while at the PRA. One would make a series of logically connected and carefully argued points, the reply would be ‘yes, all entirely correct, but that’s not how Matching Adjustment works’.
Note also Golding’s comment at the end, where he says Tunaru ‘has parameters in terms of what the research should cover. It doesn’t necessarily cover everything that the PRA talks about, because that’s not what we’ve commissioned him to do’. What exactly are the ‘parameters in terms of what the research should cover’?
A transcript of the exchange is below.
Paul Fulcher (Milliman)
Tom Kenny (Just Group, Chair)
Charles Golding (Golding Partners,Deputy Chair)
Alex Mockridge (Legal and General)
Raj Saundh (EY)
Scott Robertson (Phoenix)
Question from David Land (Rothesay Life)
DL: My name’s David Land. I guess I was surprised that you were arguing about the differences between option modelling when you haven’t yet fixed the right method of calculating the forward. That seemed like a pretty major source of possible error. And I don’t really understand why there’s much dispute about what the forward should be. I guess … it’s an interview question that I have asked for 20 odd years is, how do you calculate the price of a house that you want to exchange the money for in a year’s time, and the candidates who get the job are the ones who understand that it’s the difference between the financing rate for the house, and the rental yield on the house, and the candidates who don’t get the job are the ones who think it’s got something to do with what house prices are going to do over the intervening year. And the people here – half of them – seem to think it’s a good idea to think about what house prices are going to do over the period of the option. I wonder if someone could help me understand that.
[Pause]
PF: I’m surprised this hasn’t come up before, and thank you for raising that.
CG: I’ll make one observation. It depends what you are using the modelling for. So, if you are trying to model cashflows and annuity liabilities and you’re trying to model cashflows, then some sort of option pricing isn’t necessarily what you want. You actually want to project forward what actually is going to occur from your mortgages, how they are going to be redeemed, and what the no negative equity cost will be, so you have to do that under various scenarios. It’s more of a cashflow type of thing, not an option pricing thing. I’m not sure that’s totally answering what you’re saying, and I can see what you’re saying. I was hoping someone else would answer those sorts of questions.
TK: The debate has been around whether or not option pricing for the cashflow modelling is what you should be using, so that’s the debate we’ve been having
CG: I think there’s another thing about option pricing. Investment bankers haven’t typically been valuing 30 year options, which they could be on these things, so we’re trying to extend, if you like, extrapolate, something that investment bankers have used for shorter term options into something that’s long term, is that right?
DL: I don’t disagree that it’s difficult to come up with an actual number, and that there’s a large range of possible funding rates that you could think about. The PRA thinks that you could possibly fund a house at libor flat, which seems remarkably difficult.
CG: You can sort of see why people are concerned about some of these things, because …
DL: Some sort of estimate of long term rental yields is also very difficult.
CG: Also, if you are looking at a Black Scholes, and if you are using risk free rate, and if you are receiving some sort of constant rental yield, current risk free rates are maybe artificially low, because of quantitative easing and things like that, so that put option’s pretty much in the money, you know? There’s a question about whether that’s right or wrong. So there are lots of issues, and I agree with you. I don’t know the answer.
PF I think the working party won’t have had a chance to digest it [i.e. PS 31/18]. There’s quite a debate in the PRA paper, I think. A lot of people made comments to the PRA about the cost of funding, is it really risk free, it’s more like libor minus a credit adjustment, so it’s Sonia flat, I suppose. Whether the Matching Adjustment is a real world calculation, people made the analogy to corporate bonds. If we valued corporate bonds consistently we would knock off the CDS spread. That would be a fairly obvious question to ask one of your interview candidates, but that’s not the way the Matching Adjustment works. To be fair, the PRA, in their paper, gave quite robust pushbacks on those pushbacks, so I think that’s something that, as a profession, and as a working party, digesting what’s in there, and feeding that into the academic research that’s being done hopefully will leave us in a better place, but they are all very valuable points.
CG: We have passed a copy of the PRA’s latest paper to the academic …
PF: If people haven’t read it, it’s definitely worth …
CG: … he is going to look at those, although he has parameters in terms of what the research should cover. It doesn’t necessarily cover everything that the PRA talks about, because that’s not what we’ve commissioned him to do.
PF: If people haven’t read it, the PRA paper is definitely worth a read. Not so much the end outcome, although the end outcome is interesting, but the rationale for [how] they got there does raise a lot of these issues and debate the points in a way that I think is worthy of reflection and may be challenged, may be accepted, but I think it’s a very valid contribution to the debate.