International Capital Solutions Dynamic Asset Liability Management Pension

International Capital Solutions Dynamic Asset / Liability Management Pension & Investment December 2006 © Nomura Holding America Inc.

International Capital Solutions Main Objectives of Strategic ALM n Defining risk measures consistently with day-to-day risk management systems but appropriately for strategic decision making n Assessing Enterprise-wide risk: n Consistent across asset and liability side and different risk facets n Long-term horizon to incorporate extreme market conditions, fat tails of risk distributions and dynamic correlations n Simultaneous construction of cash flows and MTM distributions n Using risk budgeting, identify the optimal trade-off between the earnings objectives and capital constraints n Finding strategic hedge for transitioning to the optimal portfolio n Using stress testing to confirm that the chosen strategic optimal direction is robust © Nomura Holding America Inc. 2

International Capital Solutions Mean-Variance vs. Strategic Portfolio Analysis n Mean-Variance portfolio optimization works well for active portfolio management over a short term horizon n For strategic allocation over longer time horizon, variance doesn’t always represent an adequate measure of risk especially when: n Credit risk is present and extreme events are possible n Volatilities and correlations break from historical patterns n With Introduction of “Fat Tailed VAR” n The advantages of traditional approach are preserved: intuitive measure of risk expressed as amount of losses over given time horizon with a given probability n All types of risk are evaluated consistently n No standard statistical distributions are imposed on variables that do not closely follow them n The impact of extreme events is naturally incorporated into risk evaluation © Nomura Holding America Inc. 3

International Capital Solutions Sources of Fat-Tailed Risk n “Credit paradox – Investment expertise is usually focused on specific products or geographic regions that might lead to lack of diversification n Dynamic Co-variances – Most major market downturns are associated with abrupt changes in volatilities and correlations of traded instruments n Rare events (“jumps”) – Irrecoverable losses that have to be realized almost immediately (defaults, downgrades below the lowest allowed credit rating, etc) Dynamic Correlations n Correlations between risk factors are not static, they change dramatically especially during crises n There are two fundamental ways to asses dynamic correlation: n Changes over time in correlation regime due to macro-economic market conditions n Event-driven changes (implied dynamic correlation - cross-sector impact of an event) n Forward-looking simulation of the major drivers of risk should incorporate the dynamic correlations © Nomura Holding America Inc. 4

International Capital Solutions Overview of Analytical Process n New market and business developments create a need to combine the traditional Asset / Liability and Asset Allocation techniques with the new methodologies Simulate Risk Factors Integrated Risk Assessment Bottom Up Modeling underlying risk factors; Dynamically adjusting correlations on the paths; Overlaying defaults and other extreme events © Nomura Holding America Inc. Construct Risk Distributions Economic Capital (Capital at Risk) Diagnostics Generating cash flows and portfolio values on the paths Constructing the resulting portfolio distribution Find Optimal Solutions Risk Budgeting Top Down Allocating risks to different asset classes subject to appropriate risk limits Implementation Stress Testing Constructing efficient frontier; Robust portfolio optimization and strategic hedge overlay 5

International Capital Solutions Defining Risk Measures n Worst case outcome with a given confidence interval represents a more intuitive measure of risk than volatility Solvency Distribution of Capital Reserve at Time X Best Case Net Asset Value Expected Net Asset Value 0% Years 99. 5% Worst case Net Asset Value © Nomura Holding America Inc. 6

International Capital Solutions Hedging in Dynamic Correlation environment EM FX CF EM asset Country Event © Nomura Holding America Inc. Bank Investor Domestic CF 7

International Capital Solutions Practical Implementation of FTV Methodology n We analyze the historical performance of individual benchmarks and estimate their historical returns and volatilities n For the equity and credit indices, we use their industry sector composition n For each industry sector, we model the underlying credit curves with 7 different ratings ranging from AAA to CCC levels n We simulate credit curves and on each path we simulate default events with the probability calculated from the spread level on that path n Upon each default, we impose the shock adjustment to respective industry sector allocation for all asset classes n For hedge funds and other indices that don’t have an identifiable industry allocation, we observe their historical behavior and model them as a combination of smooth growth and a possible sudden drop in value (jumps) n First, we estimate the probability of jump and the size of the jump n Then, we calculate the average growth rate during “smooth” historical behavior periods between the jumps and the corresponding volatility © Nomura Holding America Inc. 8

International Capital Solutions Asset Classes with Jumps n Analysis of the asset classes with jumpy behavior must focus not only average performance of a long period of time, but also on the probability and size of jump events. n Examining the dynamics of jumps gives additional important insight into the impact on the overall portfolio at each point in time © Nomura Holding America Inc. 9

International Capital Solutions Conclusion n Goal of the strategic ALM is to identify risk concentrations and areas where there is potential for added yield or risk mitigation via change in capital allocation n Modern ALM issues require constructing non-parametric distributions of risk n Analysis should be flexible enough to incorporate internal and external long-term views, actuarial distributions, strategic objectives and regulatory and market constraints n Solutions should be robust and sustain a substantial amount of stress-testing n Periodic reviews are required to reflect the dynamics of the portfolio, business and market conditions © Nomura Holding America Inc. 10

International Capital Solutions © Copyright 2005 Nomura Securities International, Inc. Additional information is available upon request. The information contained herein is based on sources that we believe to be reliable, but we do not represent that it is accurate or complete. It is not to be considered as an offer to sell or solicitation of an offer to buy the securities or other products discussed herein. Any commentary contained herein was prepared by non-research personnel. This is not a research report and the commentary contained herein should not be considered to be research. All prices, yields and opinions expressed are indicative only and are subject to change without notice. Nomura Securities International, Inc. and its affiliates (collectively, "Nomura") may have a position in the securities or other products discussed herein, and may make purchases from and/or sales to customers on a principal basis or as agent for another person. Nomura also may have acted as an underwriter of such securities or other products, and may currently be providing investment banking services to the issuers of such securities or products. © Nomura Holding America Inc. 11