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  • Titill er á ensku Interest Rate Risk in the Icelandic Index-linked Bond Market. Effects of the Pension System’s Actuarial Valuation
  • Meistara
  • Útdráttur er á ensku

    This thesis attempts to evaluate how the rules regarding the actuarial valuation of the pension funds in Iceland affect interest rate risk on the index-linked bond market. It was discovered that not only does actuarial valuation affect the management of interest rate risk in the index-linked bond market, but it also causes abnormal price formation. A few factors are discussed regarding how and why the pension funds might influence the index-linked market. These factors include the size of the pension system, especially on the bond market where its share of index-linked HFF bonds is steadily increasing, and the possibility of how the limiting effect of capital controls on investment options might play a role. It is probable that these factors contribute to the influence of actuarial valuation on the index-linked market. The valuation seems to create an unusual incentive for the pension funds, with the 3.5% discount rate rule at its center as an investment benchmark for the pension funds, with the repercussions of failing to meet an ever-looming actuarial valuation standard.
    A hypothesis was formulated, stating how actuarial gains, or losses, should be the same on the index-linked market. This was then further developed into a theoretical model, which established the importance of the 3.5% discount rate rule by implying a constant forward rate of 3.5%. By placing the theoretical model in the context of interest rate risk and duration immunization strategy, it was discovered that there is no such risk, as any interest rate shock would affect each bond equally.
    The theoretical model was tested in four different ways using market data, over several time intervals, with and without the HFF 14 bond. This was done against two null-hypotheses: that the market moves according to parallel interest rate movements, and that the market moves according to the proposed model. It was discovered that the shape of the yield curve conforms to a large extent to the model’s prediction, and a test of variance of the price changes indicated the applicability of the model, especially for longer maturities. Then the model’s prediction of equal price changes was tested with regression, which further indicated that the model fits well for the longer maturities, especially over the longer time intervals. The null-hypothesis for the model could therefore not be rejected, while the null-hypothesis of parallel movements was rejected. In the final test, a principal component analysis of the spot rate curve indicated that the model fits well for the longer time intervals, failing to reject the model’s null-hypothesis but simultaneously rejecting the null-hypothesis of parallel movements.
    The underlying theme of these tests is that the model has considerable explanatory power, especially for the longer maturities, while also indicating that the model holds true for maturities over the middle term. This essentially means that the interest rate risk on the index-linked market is greatly overestimated, particularly for the long term, indicating that there is no need to manage interest rate risk on the longer end of the index-linked term structure.

  • 16.9.2016

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