Introduction to Derivative Products and DFA Lawrence A. Berger, Ph.D. –Swiss Re New Markets Daniel B. Isaac, FCAS –Falcon Asset Management Division of Swiss Re DFA Seminar: Managing Risk in a Portfolio Context

What Is A Derivative? Financial instrument whose value is derived from the performance of an “underlying asset” Refer to “cash price,” or “spot price” of the underlying

What Is An Underlying Asset? Can be anything Performance should be quantifiable Some examples are: –Interest Rates –Equities –Foreign Exchange Rates –Commodities –Indices –Loss Ratios

How Is A Derivative Created? Derivative product is a contractual agreement between two parties to either: –exchange cash flows, or –have one party assume a risk of the other party for a price Derivative product uses the “underlying asset” as a basis for the exchange

Options An Option Contract gives the owner the right, but not the obligation, to buy or sell an underlying asset at an exercise price on or before an agreed date –Call = Right to buy at X –Put = Right to sell at X

Options V P V P Buy A Put V P V P Buy A Call Sell A PutSell A Call

Options Options have a Time Value and an Intrinsic Value Call option value Time value P V Intrinsic value

Options Summary Intrinsic Value –Call = Max(P-X,0) –Put = Max(X-P,0) Option Premium = Intrinsic value plus time value

Pricing an Option Calculations dependent on several factors –Spot price of underlying asset –Strike price - price at which option allows owner to purchase or sell underlying asset –Interest rates –Volatility - measure of frequency and relative size of changes in price of underlying asset –Time to expiration

Volatility Probability Price of Underlying Asset Strike Price Fwd Price Low Vol. Asset High Vol. Asset

Interest Rate Cap An agreement where the seller agrees to pay the buyer, in return for a premium, the difference between the reference rate and an agreed strike rate should the reference rate rise above the strike

Cap Payoff Profile Cap Interest Rate Gain/Loss Strike Premium

Cap = Hedge High Rates An interest rate cap is essentially an insurance policy against interest rates rising A cap buyer is protected against rates rising beyond the strike A cap seller receives a fee and gives up return if rates rise beyond strike

Double Trigger Cover Reinsured pays a premium to purchase cover if two different risk events occur –The correlations between the two events are low or non- existent –Lack of correlation allows for lower premiums Example: interest rate option with catastrophe trigger –Option protects against losses on portfolio of fixed income instruments –Option is exercisable only after Cat event Interest Rates Catastrophic Event No Yes IncreaseDecrease No Cover Sell Assets, Pay Losses No Cover, No Losses Covered Collect Reinsurance No Cover, No Losses

Double Trigger Cover Equity Protection Stock Market Catastrophic Event No Yes DeclineIncrease No Cover Sell Assets, Pay Losses No Cover, No Losses Covered Collect Reinsurance No Cover, No Losses

Primarily short-tailed property business Large portion (~50%) of book is CAT exposed As a result of large liability risk, very conservative investment strategy: 20% cash, 80% bonds PCIC Company Profile

Aggregate CAT cover: 300 x 100 calendar year loss ratio from CATs Price: 30% of subject earned premium Placement: 50% No reinstatements or rebates Traditional Cover

Aggregate CAT cover: 300 x 100 calendar year loss ratio from CATs Recovery reduced based on S&P 500 return: Below 0%:No reduction Above 20%:Zero recovery Between 0% and 20%:Pro-rata reduction Price: 12.5% of subject earned premium Placement: 100% No reinstatements or rebates Dual Trigger Cover Income Smoothing

Shareholder's Equity Efficient Frontier 3-Year Time Horizon Current Reinsurance Standard Deviation of Shareholder's Equity ($mm) Shareholder's Equity ($mm) Current

Standard Deviation of Shareholder's Equity ($mm) Shareholder's Equity ($mm) CurrentTraditional CoverEfficient Frontier

Traditional Cover Current Reinsurance Dual Cover Standard Deviation of Shareholder's Equity ($mm) Shareholder's Equity ($mm) Traditional CoverCurrentDual CoverEfficient Frontier

Similar book to PCIC More heavily reinsured More aggressive investment strategy: 50% stocks, 50% short-term bonds Myth Company Profile

Aggregate CAT cover: 300 x 100 calendar year loss ratio from CATs Price: 25% of subject earned premium Placement: 50% No reinstatements or rebates Traditional Cover

Notional Amount: 75% of earned premium Trigger: Calendar year loss ratio of at least 75% Recovery based on S&P 500 return: Below -20%:100% of notional Above 0%:Zero recovery Between 0% and -20%:Pro-rata reduction Price: 3% of earned premium Placement: 100% No reinstatements or rebates Dual Trigger Cover Catastrophe Protection