Session 6 Estimating a Liquidity Risk Premium from Fixed Income Yields. Ivor Krol

Transcription

1 Session 6 Estimating a Liquidity Risk Premium from Fixed Income Yields Ivor Krol

2 Introduction We understand that a Designated Group has been assigned by the CIA to undertake a review of solvency commuted value standards Part of this review involves examining the current 90 bps premium prescribed as a spread for liquidity in commuted value discount rates Our objective is to provide the Designated Group with insight into the liquidity risk premium from the perspective of Canadian fixed income markets To do so, we will examine different types of fixed income securities which incorporate varying degrees of liquidity premia in their pricing 2

3 The Liquidity Risk Premium Can be defined as the higher price of an asset attributable to the ease with which it can be traded at higher volumes and lower costs While not directly observable in its pure form, there is broad consensus as to its existence across different markets Important characteristics of the liquidity premium: Varies by market and can be substantial Influenced by broader macro-economic conditions Time-varying and prone to instability 3

4 Estimating the Liquidity Risk Premium Isolating an estimate of the pure liquidity premium is challenging due to: Inherent latency of the premium Presence of unrelated risk premia that are also difficult to isolate and extract Market-depth and data issues We will look at different types of fixed income securities where there is a rationale for the presence of a liquidity premium in the pricing Commercial Mortgages Conventional Mortgages Provincial Bonds We will also consider whether there is rationale for a term-structure to the liquidity premium 4

5 Commercial Mortgages CMHC securities explicitly backed by the Government of Canada Much of the observed spread could therefore be reasonably attributed to liquidity risk Spreads on multi-family CMHC insured mortgages may be a useful lower bound because the typical term (5-10 years) is shorter than the typical pension promise PH&N IM analysis using historical data over the period December 2006 September Source: FTSE TMX Global Debt Capital Markets Inc. 5

6 Conventional Mortgages High quality, first mortgages, on income producing properties with conservative loan metrics (to mitigate excess credit spread risk) No active secondary market implies a significant portion of the observed spread is likely due to the securities illiquidity PH&N IM analysis using historical data over the period December 2006 September Source: FTSE TMX Global Debt Capital Markets Inc. 6

7 Provincial Bonds Provincial bonds are characterized by a very high credit quality We believe that the Provincial yield spread over Gov t of Canada bonds is largely explained by actual or perceived differences in liquidity rather than credit fundamentals Potentially useful for considering a lower bound on the liquidity premium PH&N IM analysis using historical data over the period August 1976 September Source: FTSE TMX Global Debt Capital Markets Inc. 7

8 Term Structure of the Liquidity Risk Premium Theory: Investors demand a risk premium for holding longer term assets to compensate for the undiversifiable risk of changes in interest rates Practice: Yield curves are normally upward sloping and exhibit a term premium structure consistent with theoretical arguments Term premia are also observable across different risk factors, e.g. Credit Spreads Break-Even Inflation Implied Volatilities It is reasonable to expect liquidity risk to display a term structure relationship as well 8

9 Term Structure of the Liquidity Risk Premium PH&N IM analysis using historical data over the period December 1979 September Source: FTSE TMX Global Debt Capital Markets Inc. 9

10 Concluding Remarks There is clear evidence of the existence of a liquidity risk premium In practice, it is difficult to reliably and consistently pin point the value of the pure liquidity premium Based on our analysis, we believe a reasonable estimate for a static liquidity premium would be between 70 and 120 bps Using a time-varying, market-linked estimator would be more consistent with a mark-to-market assessment of the economic cost of liabilities Adding a term premium for liquidity would also be reasonable in keeping with both theory and practice 10