Pension Funds IRR Hedging and EMIR: ongoing Concerns

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Pension

Funds IRR

Hedging and

EMIR:

Ongoing

Concerns

Master Thesis

Monica Anghel

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Acknowledgements

I would first like to thank my thesis supervisor, Damian Chen, of the Economics and Business faculty at University of Amsterdam. Prof. Chen was always open whenever I ran into a trouble spot or had a question about my research or writing. He consistently allowed this paper to be my own work, but steered me in the right the direction whenever he thought I needed it. I would also like to thank Mr. Bart Bos, head of the pension supervision department at the De Nederlandsche Bank for giving me the opportunity to do the thesis internship. The experience this internship provided me as well as the possibility to use confidential data were very valuable for me. The dedicated work culture I encountered here will be my model from now onwards.

Statement of Originality

This document is written by Monica Anghel, who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Pension funds IRR hedging and EMIR regulation: Ongoing Concerns

Abstract

This paper analyzes the implications of the European Market Infrastructure Regulation on the Dutch pension funds liquidity risk. New rules in the regulatory framework have changed the conditions under which pension funds can invest in derivatives such as interest rate derivatives. The most common over-the-counter derivatives (swaps and credit default swaps) will be cleared under the new law and the clearing counterparties (CCP’s) are to collect any collateral involved in the contract. CCP’s accept only cash payments and institutional investors such as pension funds do not generally possess large amounts of cash. Therefore, pension funds investment decisions face a trade-off between interest rate risk and liquidity risk. This thesis quantifies the size of the variation margin calls and presents an analysis of how feasible it is to meet these requirements under multiple stress scenarios. These results are accompanied by an analysis of how pension funds’ balance sheets will change as a result off selling assets to generate cash.

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1. Introduction

1.1 Motivation

Like in many other European Union Member States, the Dutch pension system is a multi-pillar system, with an important funded second multi-pillar. These features make the retirement scheme sustainable as opposed to Pay-As-You-Go systems. However, since the second pillar is funded on a capital basis, it can only work as long as the accumulated contributions and earned returns can cover all liabilities. If for whatever reason the funded pillar cannot provide the promised payments to retirees, the system collapses and loses credibility. Pension funds generally invest conservatively and assure they have enough funds to cover payments, a practice which is best known as Liability Driven Investment. The recently adopted “Regulation (EU) No 648/2012” has put the activities of pension funds in danger since they now potentially face liquidity risk. In order to comply with new regulation, pension funds needs to pay in cash any variation margin call involved with the derivatives they invested in. The fact that pension funds do not hold large amounts of cash can lead to a situation in which they need to enter repo contracts in order to generate more cash or even sell assets. This in itself is not a big concern, but if variation margin calls are correlated with bad economic outcomes, then these collateral requirements will be high when asset prices are depressed. Being forced to sell assets during fire sales dramatically impacts the coverage ratio of the fund. In addition to this exogenous risk, there is also the risk that if all pension funds need to generate cash at the same time, they will increase the supply for some assets on the market, thus decreasing the price further. No solution has yet been found and as long as negotiations are still taking place, pension funds are temporary exempted from this rule.

The motivation for this research is to answer whether or not the new EMIR regulation puts the Dutch funded pension pillar at risk. Shedding light on the issue is important since it highlights how important derivatives are for overall sustainability. Do pension funds have other alternatives?

The main goal is to get an approximation of the liquidity risk that the pension sector might face. These amounts are calculated under different stress scenarios and the analysis discusses possible implications on how the balance sheets will change.

This thesis is structured as following: Section 1 is the introduction which presents the background of the topic, some literature review, the relevant theory and it also familiarizes readers with the Dutch pension system. Section 2 focuses on the description of the data that will be used in this paper. Section 3 is a summary the methodology and the points that

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will be considered. Section 4 is dedicated to showing the results. Section 5 highlights the conclusions as well as the possible extensions.

1.2 Background and Theory

1.2.1 The Need for Regulation

After the Great Financial Crisis of 2008-2009, the regulatory landscape has changed significantly. Deregulation accompanied by financial innovations, such as derivatives and securitization, were some of the factors that contributed to the financial meltdown. (Crotty, 2009)

Derivatives are financial securities with a value based on an underlying class of assets. Derivatives can be traded on an exchange or Over-the-counter (OTC). The first type is standardized while the second one better fits counterparties needs. Evaluating OTC derivatives, however, are more troublesome than the standardized ones. This is because the details regarding OTC derivatives are known only to the parties involved in the contract and therefore the information is not available for outsiders to be able to price them

properly. (European Commission, 2015) During the financial crisis, economic agents discovered that the risk inherent to these instruments was underestimated considerably. (Crotty, 2009).

At an international level, the Basel Committee on Banking Supervision has created the Basel III framework to strengthen the international financial system. At an EU level, “Regulation (EU) No 648/2012” intends to tackle systemic risk and to improve transparency in the OTC derivative market. (European Parliament and Council, 2012). Its objectives are reached by implementing mandatory clearing for all the OTC contracts as well as requiring clearing counterparties to report the transactions. This enables authorities to assess better overall market risk as well as vulnerabilities (Abad et al., 2016).

The new regulation will strengthen the resilience of the financial system in the EU, but phasing in is troublesome for many reasons. The new framework poses significant challenges for funded pension systems in particular, since their business model differs significantly compared to other involved institutions. (European Parliament and Council, 2012)

1.2.2 The Dutch Pension system

The funded pillar of the Dutch retirement scheme has a quasi-mandatory

participation and covers about 90% employees across the country. Net replacement rates of income range from 90-103% (A. M. de Kruijf, 2018) which is the result of the mandatory pension savings. The biggest and most important pension funds in the Netherlands hold

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50% of total pension assets. (Preesman, 2015). All pension funds are under the supervision of the Dutch National Bank (DNB) and the Dutch Authority of Financial Markets (AFM).

Pension funds are required by law to maintain minimum required own funds. This is an amount of assets a fund must hold in order to cover all liabilities and also an extra buffer to absorb any market shocks. Today the coverage ratio has reached 104.5% on average in Q3 2017, still under the required 123.5%. A standard model is provided for pension funds to calculate this ratio (The Nederlandsche Bank, 2015), but a partial or full internal model can be used under certain circumstances. Even if not explicit, implicitly the interest rate risk that pension funds face increases this amount of required capital. Because pension funds do not have shareholders, required capital can be raised by increasing

contributions of employees or reducing pension benefits. The latter option is by law a solution of last resort. There are two methods to reduce IRR: correct for duration mismatch on the balance sheet or hedge risk by using derivatives. It is important to add at this point that Dutch pension funds hedge interest rate risk through derivatives, at proportions ranging from 0% to 100%, with an average of 41.6%. Therefore, these contracts are important as they directly affect interest rate risk exposure, which in turn is an important risk factor that affects the required own funds ratio.

1.2.3 Interest Rate risk

Pension funds are investors with long-term liabilities. Their investment decisions mainly intend to cover these liabilities (Liability Driven Investment). In the Netherlands, most of the pension funds are organized as Defined Benefit (DB) systems, meaning that they need to provide pre-calculated pension incomes regardless of economic conditions. This leads to a situation where it is more difficult to meet promised payments. If future interest rates are uncertain, the present value of both returns and liabilities can change, and therefore there is risk of being underfunded. Even in the case of investing in fixed interest rate assets, the interest rate still influences the present value of investments through the discounting factor (Hellwig, 1993).

Interest rate risk generally arises when there is a duration mismatch between assets and liabilities. For pension funds, assets have a considerably shorter duration than

liabilities. If at any point in time liabilities have the same value as assets but longer

duration, a decrease in interest rates will increase the value of liabilities significantly above the value of assets. This is because it affects the liabilities for a longer amount of time (Kaufman, 1984).

One solution to reduce interest rate risk is to increase the duration of assets to match the duration of liabilities. Doing this would assure a synchronized movement of the present value of liabilities and assets. While this protects pension funds from interest rates

movements, complete elimination of duration mismatch and interest rate risk is not desirable (Kaufman, 1984). One of the reasons is that such risk-free investment lowers expected returns, and pension funds cannot therefore cover the DB pension payments.

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To summarize, pension funds need to seek other ways to improve their investment positions. Derivatives are beneficial innovations that help hedge risk and bring positive welfare to both parties. Examples of such derivatives are the Interest Rate Derivatives (IRD’s), in particular the interest rate swaps and swap options. Pension funds extensively avoid interest rate risk using these securities.

1.2.4 Interest Rate derivatives

Interest rate derivatives are financial instruments whose underlying value depends on fluctuations in the interest rate. Interest rate swaps involve an agreement to exchange cash flows at specified moments in time. These cash flows are based on two legs: the

floating leg and the fixed leg. The first is the counterparty who transfers to the other an

amount tied to the prevailing interest rate while the other transfers an amount dependent on a pre-determined/fixed interest rate. The contract is agreed upon a notional amount that does not need to exchange hands, and at fixed dates (usually 6 months) the fixed leg pays a coupon based on a fixed rate and receives in exchange a coupon based on floating rate (Smith, Smithson, & Wakeman, 1988). The gross amounts of payments do not

exchange hands; only the netted amounts change hands. When a swap contract is signed, the initial value is 0. As interest rates change, so does the value of the contract. From the point of view of the fixed leg party, the value of the contract is higher than 0 when interest rates increase. That is, the party who wants to insure against the risks of increasing interest rates is compensated with net payment from counterparty when that happens. Thus when the value of the contract is positive and non-zero, it provides value to one party to the detriment of the other.

Another important insight of swap contracts is that the value at expiration date is zero. The last exchange made upon swaps termination equates the present value of both legs, and therefore value is zero (Gupta & Subrahmanyam, 1999) . A popular method of evaluation is to consider swap contracts as a series of forward rate agreements (FRA). The cash flows of IRS resemble a series of FRA expiring at consecutive dates. These series are known as strips and they usually come accompanied by a cash investment in the near term (Labuszewski, 2013). These strips are based on interest rate forwards and determine the calculation of the yield curve of the swaps. Moreover, the price of these FRA’s is based on the prices of Eurocurrency features. The high frequency trading of this class of derivatives makes their pricing more reliable

1.2.5 Collateralization

Interest Rates Swaps are not centralized, only the two parties involved know the terms and conditions of the contract. The lack of transparency of IRS makes it difficult to evaluate true risk exposure of agents on financial markets.

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It is however argued that swaps are default-free securities and they should be priced and discounted accordingly. This is because many IRS contracts involve the use of bilateral collateralization to protect both parties from default risk. The mark-to-market

collateralization introduces intermediate cash flows altering credit characteristics and distorting traditional valuation models (Johannes & Sundaresan, 2007). An aspect that changes the valuating mechanism is the fact that marking-to-market (MTM)

collateralization implies posting on a daily basis amounts of money equal to the current value of the contract as collateral. Finally, the costly collaterals can involve cash, risk free assets or even corporate bonds. Depending on the type of underlying form of payment, collateral cost and valuation can be very difficult to estimate.

The use of collateral brings clear benefits, such as facilitating risk hedging and limiting counterparty default risk. (Smith, Smithson, & Wakeman, 1988). However, the value of the collateral and the swap contract strongly depends on what form of payment is accepted as capital. The Bank of International Settlements in cooperation with the Basel Committee have designed a policy framework to account for this issue. Special attention has been given to initial margins and variation margins. The first refers to a practice that involves paying an upfront collateral when signing in the contract. Appropriate haircuts are applied as well as liquidity considerations being accounted for (Basel Committee, 2015) . One insight is that this regulation recognizes a variety of highly liquid assets as eligible

collateral. While posting more risky assets can be accounted for by the use of haircuts and other valuation methods, it can be a non-transparent practice.

Another concern regarding posting different classes of assets is that, while initial margins cannot be accessed, variation margins can be used by counterparties. This means that a certain bond can be sold after a reset date and at the expiration date of the contract it will be replaced. This raises the question to what extend one can replace a class of assets with another. Allowing multiple classes of assets to be eligible for collateral raises multiple problems for collateral evaluation. This can be deemed as one of the reasons why EMIR CCP’s accept only cash.

1.3 European Market Infrastructure Regulation

1.3.1 Before EMIR

Before adoption, the OTC market lacked transparency, had insufficient mitigation of default risk and insufficient mitigation of operational risk. Considering the international characteristic of derivatives, regulation at individual state level has limited power. Moreover, uncoordinated actions or regulations can lead to regulatory arbitrage.

The first issue, lack of information meant that regulators in a particular country could not assess the overall market. Merging information from different sources was difficult. (European Commission, 2010). Not only did regulators need information to take action, but also market participants themselves could have benefited from overall market assessment.

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Any party of an agreement only knew the direct exposure to the counterparty, but it had no information about the indirect exposure to other economic agents. Collaterals, for example, were decided based upon a perceived level of risk. Since this perceived level was underestimated (no indirect exposure could have been accounted for), the collateralized contracts were not risk-free.

In addition, counterparty default risk was not sufficiently mitigated. Traditional bilateral collateral agreement mitigates risk if and only if it fulfils four conditions: frequent and accurate calculation of risk exposure, quick exchange of collateral, it covers overall counterparty potential risk and is legally enforceable. Bilateral agreements failed in many of these aspects and led to the overall risk accumulation.

1.3.2 “Regulation (EU) No 648/2012”

The EMIR regulation is in line with international efforts to create transparency in derivative markets. Its content specifies what instruments are to be cleared, as well as how CCP’s get licenses, how trade repositories get licensees, recognition of third-country

agents, eligible collateral, permanent exceptions and temporary exceptions. This section will cover the main highlights from the regulation and some comments.

The regulation’s purpose is to set rules on the clearing of OTC derivatives and impose bilateral risk-management requirements for those securities which will not be cleared. The agents that are subject to this regulation are centralized counterparties, clearing members, trade repositories, financial institutions, non-financial institutions and trading venues. The actual classes of securities that are subject to clearing obligations are: basis swaps classes, fixed-to-float interest rate swaps, forward rate agreement classes, overnight index swaps classes and European untranched Index CDS Classes (Regulation (EU) 2015/2205,

Regulation (EU) 2016/592 and Regulation (EU) 2016/1178). Other classes are also being considered at the moment, without a decision yet being made. The derivatives that will not be cleared are required by this regulation however to adopt appropriate risk-mitigating techniques, such as bilateral collateralization.

Central counterparties need to get authorization from the competent authority governing the country where they are established. After receiving the authorization and after fulfilling all requirements, CCP’s can operate in the whole Union. In the process of applying for authorization, CCPs state which instruments they intend to clear and they receive approval if they are deemed competent to manage those types of contracts. Trade repositories on the other hand can operate only if they get authorization directly from ESMA. Today there are 17 CCPs authorized to activate in the EU and 6 trade repositories that record the contracts.

Acceptable eligible collateral is an important topic in the regulation. Initial margins, variation margins and payments to the default fund are to be made in cash (European Central Bank, 2013). Initial margins cannot be used freely by a CCP, while variation margins

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can be transferred. This gives an intuitive reason why cash is preferred, since it easier to reuse.

The concern that pension funds cannot fulfil these requirements lead to the adoption of Article 89 on Transitional Provisions. This article states the temporary 3 year period exceptions for pension funds from clearing obligation, as well as presents the possibility of a further exception period of maximum 3 years. Other exceptions from clearing are intra-brands transactions, but these exceptions are permanent.

The clearing procedure can be done directly or indirectly. The first way involves counterparties directly interacting with the CCP, fulfilling certain requirements and paying specified fees. More technically, when it is cleared, a contract between two counterparties becomes two contracts, having the CCP on one side and each counterparty on the other. Clearing dissolves the interaction between counterparties in such a way that the CCP holds both positions. The second type involves counterparties using a clearing member to clear transactions. This means that CCPs interact with an intermediary, such as large financial institution. Counterparties in these cases tend to be economic agents of smaller sizes that would not meet requirements to be a safe clearing member for CCP. Since they need an intermediary, they can become clients of clearing members. The technical details of how the contracts get cleared involve creating a chain of bac-to-back contracts that contain the positions and sized of the positions held by initial counterparties until they are hold directly by a CCP. This procedure is not straightforward and further instructions are provided by EMIR (Jones, 2014).

EMIR makes reporting contracts by CCPs mandatory. However, data collecting has proven to be troublesome. While a large part of the market has already been cleared and a broad picture of market interactions is available for analysis, many trade repositories provide data that cannot be used. This is because the EMIR provides little guidance and standards for the data reporting procedures (Rousová, Kulmala, & Osiewicz, 2015). Further work is done on the adoption of a unique global trade identification system (UTI) that will make it easy to match trades either across borders or which are subject to double

reporting.

1.3.3 Temporary Clearing Exceptions for Pension Schemes Arrangements (PSAs) In August 2018 the temporary exception for pension schemes will expire. This

exceptions permits pension funds to still pay margin calls with high quality liquid assets and necessarily cash. Many proposals have been forwarded, but agreements were not

established. Some propositions have clear advantages, but there is fear regarding their contribution to future risk accumulation. This section highlight the discussions that took place so far.

The first possible solution is to make the temporary exception permanent. While PSAs would no longer pay cash collateral, they would still be subject to risk-management requirements for non-cleared contracts. This means that they would post initial margins

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and variation margins with their counterparties. This collateral can involve multiple classes of liquid assets and it still helps to mitigate counterparty risk. Nonetheless, the Dutch government has opposed this option saying that it weakens the scope of the reform. It is believed that the significant positions held by PSAs in the derivative market makes them an important target for clearing obligations (Boschman, 2017). It is true that out of the total EU OTC market of 300 trillion euros notional value, 70% is represented by interest rates derivatives. But in this large IRD market, almost 75% of the notional amount of trades takes place between G16 (an industry group comprising the largest derivatives dealers) and Banks, while only 25% is accounted for by all the other market participants together, such as pension funds, insurance companies, corporations etc. (Abad et al., 2016).

A second option is to allow PSAs to post government bonds as collateral. The advantage of this measure is that it protects the posting counterparty from selling assets such as bonds during fire sales or when there is an increased supply in the market. While this is a beneficial practice for pension funds, it is not practical for CCPs. As stated in previous sections, CCPs intermediate series of transactions. If margin calls are paid in bonds, then different types of bonds will be exchanged. If the quality of the bonds is not equivalent, then this leads to the inability of CCPs to pay back collateral. Another issue with this practice is that if bond values are correlated with market conditions, then posting government bonds can lead to systematic risk accumulation.

The final option mentioned is to reduce the initial margin requirements for pension funds since they pose little counterparty risk. In addition to restructuring margin

requirements for low risk investors such as pension funds (PGGM, 2013), the pension funds position paper also suggest implementing a threshold amount in the technical

requirements, as to protect funds even further. Since a clearing member (CM) has the right to ask three times the initial margins required by the clearing house , this would put

pension funds in a situation to face counterparty risk with the CM (usually a bank). This proposition has not been discussed further by the official negotiations. The role of CCPs is central to macro prudential policy and the regulation should assure the solvency and liquidity of Centralized Counterparties. Therefore, many aspects of the regulation put high requirements for clearing members who in turn mitigate risk by requiring high collateral from clients.

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2. Data overview

This section describes the data that will be used later. In case the exception is lifted, pension funds would pay initial margins and variation margins. These amounts depend on the actual position holdings by pension funds. Therefore, this section starts with an overview of the pension fund’s portfolio and asset holdings.

The information provided is based on data from the Dutch National Bank.The paper looks at the data starting with the 1st_{quarter of 2012 (K1 2012) and contains quarterly data}

until 2018 first quarter.Derivative and asset holdings have changed throughout this period but not significantly. Many values are shown only for 2017 K4. The paper presents average values for the whole pension sector. There are in total 267 registered pension funds, divided in groups from 1 to 5, according to their size. There are no funds that have size 5 (T5), this group having the function of a cap on size. In group 4 (T4) there are the 5 biggest pension funds in the Netherlands, in group 3 there are 29 medium sized pension funds and in group 2 there are 181 (T2) pension funds of reduced size. Group 1 (T1) contains 52 pension funds, but it will be excluded from the summary statistics because it does not cover much of the working population. Dropping 52 funds from the analysis is not a problem since many small funds are gradually disappearing. This a part of a trend in the recent decade of decreasing numbers of funds. While in the late 1990’s there were more than 1000 funds in the Netherlands, today’s number is less than a third of that and still decreasing. The following graph shows the decreasing trend in detail:

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Table 1- Market Value of Assets and Derivatives

Asset Holdings SWAP%ASSSETS DER%ASSETS CURR%ASSETS Number of Funds Whole Sector 6.268.559 1,06% 1,39% 0,31% 215

T4 149.678.348 3,16% 3,48% 0,59% 5 T3 12.824.741 1,04% 1,60% 0,50% 29 T2 994.267 -0,01% 0,30% 0,24% 181

Table 1 contains the average asset holdings and derivatives relative to assets for the whole sector as well as for each group. The average asset holdings across all funds is around 6,2 million euros. In the same time the average for the biggest funds is 149 million, 24 times more. This shows that there is a high disparity between asset holdings. There is also a contrast for the derivative holdings as percentage of assets, but less extreme: the whole sector has on average derivatives that value 1,39% of total assets and the T4 group has 3,48%. T3 and T2 hold modest derivative portfolios, of 1,6% and 0,3%. Swap holdings have a similar pattern: the whole sector has swap contracts with market values of about 1.06% of their assets. For group 4 pension funds, this percentage increases to 3.51%. T3 and T2 funds hold 1,21%% and 0,97% respectively. The second distinct class of derivatives that is important for pension funds is currency derivatives. This class also requires variation margins and initial margins. However, the market value of this class is reduced. Currency represent only 0,31% of the sector’s portfolio, 0,59% for T4 funds and 0,50% and 0,24% for T3 and T2.

The next section considers the evolution of swap portfolios across time. The market value of swaps has been quite volatile throughout the period 2012 K1-2018 K1. In the same time, the last 3 quarters have seen a more stable evolution. The notional value trend is also presented afterwards to check if it exhibits similar movements. Notional values of swap contracts are calculated by netting notional long positions and notional short positions for each fund.

Figure 2 shows the time trend of the market values of swaps, which was decreasing until 2014, then spiked in the last quarter of 2014 and then dropped until it reached a trough in 2017 K2. Some pension funds even find their swap portfolio to have a negative market value. This can be attributed to the low interest rate environment in the Euro Area. The prevailing low interest rates are expected to increase, and therefore this could bring down the market value of swap investments.

In comparison to this, the notional values of swaps have been more stable, decreasing as a percentage of total assets at a slower trend. Figure 3 shows that for the

Here, T4 refers to the pension funds that are big enough to fit in category 4. T 3 and T2 are medium and small pension funds. Currency holdings in this table refers to investments in currency derivatives. *SWAPS%ASSETS, DER%ASSETS and CURR%ASSETS refer to the proportion that swap contracts, derivative contracts and currency derivatives represent as a percentage of total assets.

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Figure 2-Evolution of Swap Market Value as % of Total Assets

whole sector this trend is stable. Group 3 funds exhibit slightly different pattern at the beginning of the period, but in the later quarters follows the same pattern. Compared to table 1 notional values of swaps are on average 20% for the whole sector. This big difference compared to the 1,06% seen before is because swaps have 0 market value initially, but there is a higher underlying notional value. Figure 3 uses data on netted notional positions of funds for the period 2012-1018, quarterly.

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Figure 3-Evolution of Swaps Notional Values as % of Total Assets

Expectations of increasing interest rates give incentives to decrease investment in swaps. There is a decrease in both notional values and market values of swaps. This fuels the prediction that if the exception is lifted, a trade-off could be created between liquidity risk and interest-rate risk, in which pension funds hedge less interest rate risk in order to manage liquidity risk better. This is because hedges become more difficult to make (cash requirements) in addition to being less profitable in a low interest rate environment.

An interest rate shock will be presented in order to show the sensitivity of the derivative and swaps portfolio. The sensitivity of currency instruments will be presented also, but the shock for this type of instrument is a 25% depreciation. In the case of a 1% increase in interest rates, as presented in table 2, the value of the swaps decreases,

becoming negative for many funds. This signifies that an increase in interest rates produces losses. On average, the whole sector loses an amount equal to 10% of their assets for the total derivative portfolio, 4,45% for swaps only and 5,78% for currency instruments. Group 4 funds lose almost 11% from their derivative portfolio, 3,9% from swaps and almost 7,8% from currency instruments market value. The present environment may be unfavorable for investing in swaps since interest rates are expected to increase rather than decrease. In the same time, the fall in market value requires the losing counterparty to pay collateral, the margin calls. This means that pension funds not only have to make a higher payments (they are the floating leg in swap contracts) at the next set date, but they need to provide a cash collateral equal to this loss as soon as the interest rate shock occurs. The liquidity needs of currency instruments will be presented in more detail in section 4.2 as well as some information about why pension funds invest in currency derivatives in section 4.3.

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Table 2- +1% Interest Rate Shock: Change in Derivatives Portfolios All the numbers are expressed as % of total assets of funds

*For currency, the market shock is a 25% depreciation.

Table 3- Sizes of Asset Classes as a % of Total Assets

T4 T3 T2 Whole sector Real Estate 10,71% 7,14% 6,16% 9,08% Equity 34,29% 31,97% 30,87% 33,17% Alternative Investments 7,88% 2,43% 1,47% 5,46% Gov Bonds 21,96% 25,16% 25,31% 23,32% Mortgage 9,17% 4,75% 4,94% 3,71% Loans 11,87% 15,99% 17,12% 13,75% Cash 3,11% 0,94% 2,45% 2,40% Hedge funds 2,64% 0,72% 0,68% 1,83% Commodities 0,38% 0,00% 0,01% 0,22% Other Investments 2,29% 0,41% 0,91% 1,57%

1% Derivatives DifferenceSwaps Difference Currency Difference

Whole Sector -10,07% -4,45% -5,78%

T4 -10,89% -3,90% -7,75%

T3 -10,01% -3,24% -6,97%

T2 -10,05% -4,67% -5,52%

Pension funds invest in portfolios that contain approximately 10 main asset classes. The biggest are by far government bonds and equity. Mortgages and loans are also common investments across pension funds. Table 3 shows the proportion of total assets for each group and also for the whole sector. Figure 4 is done for data on only group 4 pension funds, because of their importance and the fact that they cover the majority of the working population. Figure 5 shows the same allocation but among the whole pension sector. Group 4 allocates 21,96% of all assets to government bonds, which are deemed to be highly liquid and safe investments, and 34,29% to equity which is slightly more risky. The whole pension sector invests about 23,32% of its assets in government bonds and 33,17% in equity. These overview shows that pension funds generally have similar investments. One implication of this homogeneity is that in case of a market shock, all pension funds face the same situation and they can only sell the same assets. This strengthens the assumption that if all pension funds are hit by a shock and need to sell assets at the same time, they sell almost the same classes and create fire sales. This further depresses the prices of the assets and makes it difficult to generate cash.

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Figure 4-Portofolio Allocation T4 _{Figure 5- Portofolio Allocation per Sector}

Figure 6 –Portofolio Allocation T3 _{Figure 7- Portfolio Allocation T2}

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Figure 8- Equity and Government Bonds Distributions

Figures 4,5,6 &7 show that average equity and bonds holdings in the whole sector and in each group are similar. The frequency distribution of equity and bonds investments is however more diverse than captured previously. Figure 8 considershow these as

percentages of total assets are distributed across certain intervals. As can be seen, funds choose to hold different proportions of bonds, equity and “Other” in their portfolios. At the same time, while equity is more concentrated in the interval 15%-45%, government bonds proportions differ more, ranging from 0% to 60%. This means that some funds do not hold a lot of government bonds in their portofolio. They hold many different types of bonds such as corporate bonds, that are counted under the title of “Loans” in table 3. One

implication of this fact is that some funds cannot generate cash by selling only government bonds because they do not hold that many. As a result, when calculating liquidity needs after deplating government bonds holdings, there would be very extreme outliers, which do not reflect the need for more liquid assets, but rather a difference in preferences for the type of liquid assets. To account for the fact that some funds substitute investment in government bonds with investment in a wider variety of bonds like coorporate bonds, the next sections will use a new asset class, namely AAA rated bonds. This new category includes both government bonds and corporate bonds, accounting only for those which have AAA rating. Since this category might not be enough to cover all liquidity needs, the paper also looks at lower rating bondsalso, both government and corporate.

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3. Methodology

This section is dedicated to presenting the research topic and the research question of this paper. The research topic is whether pension funds can operate under new

regulation without sacrificing pension income for participating members. More specifically, do pension funds have enough cash? Sacrificing pension income in this sense means cutting down benefits due to underfunding risk. Pension funds’ investment decisions usually follow a Liability Driven Investment strategy which reduces volatility of liabilities and assures the fulfilment of the liabilities (Insight Investment, 2017). The way these strategies are constructed involves investing part of the assets to hedge the risk of changes in the present value of liabilities and the rest in assets with higher return than the liabilities growth. Therefore, higher cash holdings do not earn any return and also may also create incentives to reduce investment in swaps. Both effects can put pressure on the ability to meet liabilities. The following subsections follow the different steps in the methodology that account for multiple risk factors and economic stress.

3.1 Liquidity Needs per Risk Factor

The first step takes into account separate risk factors, such as interest rate increases or depreciations of home currency. The following methodology was chosen in order to answer the research question: firstly, data was obtained on asset portfolios and derivatives from E-line which is the DNB database; summary statistics were created containing the sizes and averages of all asset classes. The data from DNB has results for 4 standard shocks in the interest rates. The responses to the shocks were used to obtain the changes in the value of the derivatives portfolio. This is done by subtracting the initial market value from resulting market value after the. These changes are equal to the variation margin calls, therefore the absolute value of these differences is subtracted from the cash holdings. If the variation margin calls are larger than cash holding, then the missing amount to meet the call is defined here as the liquidity needs. The liquidity needs are computed for all funds and the final results answer the main research question.

After calculating the liquidity needs for the whole sector, as well as for groups 2,3 and 4 we compare these values with the asset holdings of each fund. The relative size of liquidity needs to total assets is computed. This is done in order to evaluate how much of the portfolio should be sold in order to cover margin calls. In addition to this, the liquidity needs will be also compared to different asset classes. More specifically, the paper considers the most liquid asset classes and checks if they are enough to cover liquidity needs. First, funds can simply enter repo contracts which means that they do not sell off assets but just temporarily generate money. The assets that can be used in repo markets

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are only AAA government bonds, so we first subtract liquidity needs from AAA government bonds and check if it is enough to cover liquidity needs for all funds. After this, if funds still have problems generating enough cash to cover collateral requirements, they can start selling assets. Here we use a top-down approach, so they start selling from highest rating to lowest. The funds that have liquidity needs after entering repo market will sell of AAA corporate bonds (subtract liquidity needs from AAA corporate bonds holdings) and the paper checks if liquidity needs are covered. Funds who face further problems go one step forward and sell AA bonds which have lower ratings. Again the paper checks if all funds have covered liquidity needs by subtracting them from AA bonds holdings. The process continues to A bonds if there are still funds with liquidity needs, and then to BBB rated bonds, BB-bonds and in the end to the lowest rated bonds. If there are still liquidity needs at this point for funds, they need to start selling equity since it is the most liquid asset that is still held.

In addition to this, the results section includes graphs that present the frequency distribution of the liquidity needs as percentage of assets for groups 2,3 and 4.These graphs will look at have different liquidity needs distribution. The frequency distribution graphs are based on representative intervals, taking the minimum values for each group and calculating equal intervals. More details regarding the number of funds that still have face liquidity needs after selling some assets and what group they belong to will

accompany this section. Since the sizes are very heterogeneous, the paper looks carefully at each group to check if there is a group that is more vulnerable to the regulation than others.

3.2 Liquidity Needs for Combined Risk Factors

In addition to swaps, many pension funds invest in other derivatives, most commonly being currency derivatives. While these investments are reduced for medium and small funds, the inherent risk can put further pressure on big funds. The E-line data tool contains details on the size of currency derivative investments. Again, 4 types of shocks are

provided, this time a -25% appreciation, -12,45% appreciation, +12,5% depreciation and 25% depreciation. The market value of currency derivatives decreases when the currency depreciates. In addition to this, the resulting market values after each shock will be subtracted from initial market value. Again the total market change will be derived and compared to cash holdings. The absolute value of market value change is subtracted from cash holdings and the resulting liquidity needs are computed. The same procedure is done for the total derivative portfolio as to account for other derivative investments done by some funds.

After calculating liquidity needs and market changes, a rule of thumb is used to account for combined market risks. This means that since interest rate increases are generally accompanied by currency depreciation, the next section will add the market

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changes (if negative) from currency and swaps in one column and currency and total derivatives in another column. After obtaining this total market changes, the next step is to subtract the total amount from cash holdings. It is expected that the obtained liquidity needs are bigger in this section. The relative value (percentages) of the needs to liquid assets and the frequency distribution of disinvestments needs will be presented again. 3.3 Discussion of Probability of Market Shocks

Most of the conclusions are based on events in which market shocks take place. The bigger the shock, the higher the liquidity needs and more pension funds can encounter problems in generating enough cash. However, the academic definition of a stress test is to simulate extreme but not improbable market outcomes. In order to present the results as close as possible to a stress test, the final part presents an extensive discussion of how probable are the market shocks that result in high liquidity needs. The main methodology in this last section is a historical overview of market shocks that have taken place. The data used is from Bloomberg and it uses 10Y Euro Swaps,20Y Euro Swaps, Euro/Dollar exchange rate and Euro/Yen exchange rate.

The final subsection first looks at the probability of a +1% interest rate shock and it considers the evolution of 10Y and 20Y swap interest rates in a time frame from 1989-2018 and 1994-2018 respectively. Afterwards it takes the difference from one time period to another (either quarterly, biannually or annually) and presents the distribution of the changes in the interest rates. The time frame includes years in which Euro did not exist yet, but this is solved by using interest rates on German government bonds as a proxy for Euro swap rates before 1999 (implementation of the Euro). The differences that result in this section will show how often in the past the economy experienced +1% interest rate shocks and evaluates the probability of one in the medium term (5-10 years). In addition to this, another way to look at the probability of a +1% interest rate shock is to look at a similar economy to the Euro area. In this case the paper uses the US economy because they previously had a Quantitative Easing program in place as a response to the great financial crisis similar to the one in Europe. It can be argued that the expected end to the European QE can lead to interest rate increases and possibly can lead to market shocks. Therefore, by looking at the US experience, the paper intends to evaluate what the European economy should expect as market shocks.

The last point to be covered is the probability of a 25% depreciation of the euro. This is done by using data from Bloomberg on euro/dollar exchange rate and euro/yen

exchange rate. The time frame is 1989-2018 for both exchange rates and the Deutschmark was used as an approximations for the years when the euro did not exist. The changes from one time span to another will be presented, as well as the frequency distribution of the changes in order to see how often 25% depreciations happened. An overview in the end will summarize the main conclusions of the results section as well as an appreciation of the risks pension funds might face.

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Table 4- Liquidity Needs After Interest Rate Shocks as a % of Total Assets

These numbers were calculated using all funds in the whole sector and in the whole group. Pension funds that did not have liquidity needs were counted in as 0.0%. The numbers in the remaining of the paper are calculated in a similar way, unless stated otherwise. The column labeled “No.” counts how many funds out of total have liquidity needs.

Whole Sector No. T4 No. T3 No. T2 No.

Swap Portfolio(+0,5% shock) -1,60% 146/215 -0,75% 3/5 -1,34% 21/29 -1,66% 124/181

Swap Portfolio(+1% shock) -3,46% 159/215 -1,88% 3/5 -2,76% 22/29 -3,62% 134/181

Total Derivative Portfolio(+0,5% shock) -3,96% 184/215 -3,47% 4/5 -4,26% 27/29 -3,92% 153/181

TotalDerivative Portfolio(+1% shock) -8,56% 194/215 -8,45% 4/5 -9,11% 28/29 -8,47% 161/181

4. Results and Discussions

4.1 Interest Rate Risk

This section provides empirical evidence of the liquidity risk that pension funds might face. In case the temporary exception for funds to pay non-cash collateral is lifted, pension funds would pay initial margins and variation margins in cash. These amounts depend on the actual positions held by pension funds. Therefore, this section starts by taking the absolute value of the change in the market value after the provided shocks and subtracting the available amount of cash. This difference, if negative, will be defined as liquidity needs. Afterwards, an overview of the liquidity needs and summary statistics of these amounts relative to the total assets, equity and bonds will be presented. Frequency distribution graphs will accompany the presentation.

The Dutch National Bank provides data on the market value changes of derivatives under four shocks: shocks 1&2 represent decreases in interest rates of -0.5% and -1%. Shocks 3&4 represent increases of +0.5% and +1%. When interest rates fall, there are no liquidity needs. This is because the market value of swaps increases. This is intuitive since the initial decisions to invest in swaps was made in such a way that in case interest rate drops, the swap contracts compensate funds for their losses due to increase in the value of liabilities. Table 4 shows the liquidity needs generated by shocks 3 and 4 for swaps in particular and also for the derivative portfolio as a whole.

For swaps, the increase of 0.5% in interest rates generates liquidity needs from swaps of about 1.6% for the whole pension sector and more than double that amount for an increase of 1%. Group 4 pensions have an average of 0.75% for shock 3 and 1.88% for shock 4. These numbers are lower compared to the sector. The liquidity needs for group 3 are low, 1.34% and 1.88% for shocks 3& 4. Group 2 on the other hand has the highest liquidity needs, 1.66% for shock 3 and 3.62% for shock 4.

For derivatives, liquidity needs for the whole sector are 3.96% and 8.56% respectively for 0.5% and 1% increase in interest rates. Groups 4 has 3.47% liquidity needs for shock 3 and 8.45% for shock 4. Group 3 has slightly higher averages, 4.26% and 9.11%. Group 2 has liquidity needs in between group 3 and 4. In section 4.2 liquidity needs generated due to depreciation shocks will be calculated and added up to those mentioned above.

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Figure 9 – Derivative Liquidity Needs for a +1% Increase in Interest Rates

In addition to calculating average liquidity needs from shock 4 for each group and the whole sector, this paper looks at the frequency distribution. This is done in order to

account for outliers and irregularities in observations. Figure 7 presents the frequency distribution of derivative liquidity needs resulting from a +1% increase on interest rates for each group and figure 8 presents the same distribution for swap liquidity needs. Derivative liquidity needs are distributed among a wider interval, most of the observations being captured in the interval -18% to -3%, while swap liquidity needs are mostly concentrated in the interval 6%-0%. These differences are not surprising since the total derivative portfolio also captures the sensitivity of other derivatives, apart from swaps, to interest rate

changes. Therefore, we expect that, depending on how much a pension fund desires to invest in other derivative instruments, there are bigger liquidity needs for derivatives as compared to swaps. At the same time, in both figures it can be seen that group 4 funds have liquidity needs that range within a very small interval, towards the lower end of the distribution. This can be an indication that big pension funds have rather similar cash holding and derivative portfolio (therefore the same liquidity needs), and they face

relatively modest liquidity needs (towards the lower end). Group 3 liquidity needs are also distributed within a small interval, but there still are some group 3 pension funds that have rather high liquidity needs generated from derivatives. Group 2 funds represent the most heterogeneous sample, their liquidity needs covering every interval. It seems that if extreme market shocks would take place, the most vulnerable are group 2 founds that are located at the extreme end of the interval, for both swaps and derivatives.

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Figure 10-Swap Liquidity Needs after +1% Increase in Interest Rate

After calculating liquidity needs after depleting cash holdings, this paper looks at other sources of cash. This section examines which assets can funds sell in order to cover liquidity needs. This is important for the main research question because this paper looks at how difficult it is to generate/hold more cash for pension funds. The first point to consider is that if a fund is facing liquidity needs, it cannot just sell any asset from the portfolio. The reason is the fact that pension funds need to have a certain risk profile for their portfolios at all times. Selling too many assets of one class can alter the overall exposure of a fund, resulting in a situation in which a fund takes either too much or too little risk. In addition to this, many asset classes presented in section 2 are illiquid (such as “Mortgages”, some assets under “Loans”, “Other Investments” and “Alternative

Investments”), and they cannot generate cash on short notice. Therefore, it can be reasonable to assume that in order to generate cash, a pension funds can sell only very liquid assets that do not alter overall risk profile. This can be done by participation in the repo market. Pension funds can enter either bilateral or cleared repo agreements in which they sell an asset for cash and agree to repurchase it at a point in the future. General repo agreements accept only government bonds as underlying assets, the term “collateral” also being used to describe these assets. The result of entering in such an agreement is that pension funds generate cash without altering portfolio composition.

The next table shows the liquidity needs of pension funds after entering repo

agreements to generate cash. After using government bonds in repo agreements, there are still some funds that have liquidity needs. For the derivative portfolio response, there are 50 funds whose liquidity needs are not covered after a 1% increase in interest rates. One fund is located in group 4, five founds in group 3 and the rest in group 2. The average

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In this table, liquidity needs for derivatives and swaps are presented after funds enter repo contracts and use government AAA-bond to generate cash. Compared to the previous tables, liquidity needs are calculated only for the funds that have liquidity needs.

Derivative Liquidity Needs Number Swap Liquidity Needs Number Average -3,93% 50/215 -3,04% 8/215

T4 -2,50% 1/5 none 0/5

T3 -3,44% 5/29 -0,43% 1/29

T2 -4,01% 44/181 -3,42% 7/181

Table 5-Liquidity Needs Unweighted Averages After Entering Repo Agreements as a % of Total Assets liquidity needs of all the funds with shortage of cash is 3,93% of total assets. The group 4 fund has 2,5% liquidity needs, the group 3 funds have on average 3,44% and group 2 have 4,01%. For swaps portfolio, only 8 funds have liquidity needs after a 1% increase in interest rates, one being group 3 and the rest group 2. The average across these funds is 3,04%, the group 3 fund has 0,43% liquidity needs and the group 2 funds have an average of 3,42%. As mentioned in the data description, some funds do not invest much in government bonds, but rather substitute them with a wider variety of AAA-bonds. This can be a possible explanation of why there are these few funds which cannot cover liquidity needs with repo agreements

After accounting for entering the repo market, the end of this section will look further at how can the pension funds that still have liquidity needs fulfil them. One option is to sell off some of the very liquid assets they hold, such as the remaining AAA-bonds (but not government bonds since those are already depleted) and other lower rate bonds. Firstly, the paper checks if selling AAA-bonds alone is enough to cover liquidity needs. Additionally it also accounts for some of the losses funds incur when selling bonds. In this section we also check how liquidity needs behave if there is a less strong shock, +0,5%, in addition to the 1% shock. To account for the bid-ask spread, an article from Bloomberg Opinion (Levine, 2016), where they calculated a spread of 0,6%, is reviewed. This means that when selling a bond with a market value of 100$, one receives 99.7 $ and when one want to buy the same bond he pays 100.3$. This 0.3% spread will be used for evaluating the market value of the total AAA-bonds held by funds. After subtracting this spread, the maximum amount of cash a fund can obtain is calculated. Table 6 presents the results and the remaining liquidity needs. For a 1% increase in interest rates, 26 group 2 funds still have liquidity needs generated by the derivative portfolio. Groups 4 and 3 can cover margin calls after selling AAA corporate bonds. For the swap portfolio there are fewer group 2 funds that face problems, only 4. The +0.5% shock is also provided to check liquidity needs that prevail only if extreme market shocks happen. For the 0.5% shock, there are 5 group 2 funds that face liquidity needs generated by the derivative portfolio and one group 2 fund that faces liquidity needs generated only by the swap portfolio.

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Table 7- Funds that Need to Sell Further to Cover Liquidity Needs

After selling AAA-bonds corporate bonds, 26 funds still have liquidity needs. They start selling AA-bonds, and only 5 funds still have liquidity needs. These 5 funds are presented in the table. Further selling A-bonds leaves only 2 funds with liquidity needs. If the two funds start selling BBB-bonds, only one still has liquidity needs and it can cover them if it sells of BB-bonds

Derivative liquidity needs Swap liquidity needs +1% -3,77% -3,27%

Number 26 4

+0,5% -2,01% -1,84%

Number 5 1

Fund 1 Fund 2 Fund 3 Fund 4 Fund 5 Liquidity needs after selling off AA-bonds -4,36% -0,42% -0,36% -3,91% -9,37% Liquidity needs after selling off A bonds none none none -1,33% -7,11% Liquidity needs after selling off BBB bonds none none none none -2,04% Liquidity needs after selling off BB bonds none none none none none

For an increase in the interest rate of +1%, the average liquidity needs for these funds is 3.77% from the derivative portfolio and 3.27% from the swap portfolio. In case of a 0.5% increase in interest rates, liquidity needs are 2.01% from the derivative portfolio and 1.84% from the swap portfolio.

The remaining funds with liquidity needs need to sell even more assets. A possible solution is for them to sell AA-bonds after depleting all AAA bonds. If this is done, pension funds that had liquidity needs from swaps will be able to cover them, both for 0.5% and 1% increases in interest rates. For derivatives portfolio, however, selling off AA-bonds is not enough to cover all liquidity needs for 1% increase in interest rates (it does however cover liquidity needs for 0,5% increase). There are 5 funds from group 2 left with average

liquidity needs of 3,68%. Further attempts to generate cash now involve selling off A-bonds. Again, if this is done, two funds still have liquidity needs. The remaining liquidity needs are 7,11% and 1,33% respectively. The next category of bonds that could be sold off is BBB-bonds. Doing so leads to only one fund having liquidity needs of 2,04%. This last fund can cover its liquidity needs by selling bonds even further. When selling BB-bonds, this last fund can fulfil its margin call. Table 7 shows these steps in more detail:

In this table liquidity needs were calculated after funds sell all the remaining AAA-bonds in the portfolio, mainly corporate bonds. Again, only the funds that have problems are presented, so the numbers are calculated using the reduced sample of funds with liquidity needs. The funds in this case are all from group T2

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Currency Liquidity Need (12,5% depreciation) No. Currency Liquidity Need (25% depreciation) No.

Sector Average -1,95% 168/215 -4,63% 184/215

T4 -2,08% 4/5 -5,31% 5/5

T3 -2,66% 27/29 -6,07% 28/29

T2 -1,82% 137/181 -4,35% 151/181

Table 8- Currency Liquidity Needs as % of Assets

4.2 Currency Depreciation

In section 4.1, scenarios in which interest rates would increase by 0.5% and 1% were presented. These shocks lead to a decrease in the market value of swaps and the derivative portfolio and triggered margin calls for these contracts. However, there are other market shocks that could happen and that could also trigger margin calls.

Many investments of pension funds can be in foreign assets and therefore can involve returns denominated in foreign currencies. The risk that pension funds face in this situation is the risk that the foreign currencies depreciate and the value of the returns from foreign assets drops. To protect themselves against this risk, funds enter forward contracts or future contracts in which they agree to exchange currencies at a pre-established

exchange rate in the future. These contracts that have been presented briefly in section 2 lose value, however, when the foreign currency appreciates (home currency depreciates). This new risk of depreciation triggers margin calls just as in the case of rising interest rates because the market value of the derivative contracts decreases.

The shock that we will consider in this section to calculate margin calls is the depreciation of the home currency, leading to a fall in the market value of the currency derivatives. The data provided at the DNB has two standard depreciation shocks, one of 12,5% depreciation and one of 25% depreciation. Liquidity needs will be calculated just as before by subtracting initial market value from the market value after the shock. The cash that is held by each fund will be subtracted from the difference in market value after the shock, and the result will afterwards be expressed as a percentage of total assets.

Table 8 presents the resulting liquidity needs from currency derivatives for both the

12,5% depreciation and 25% depreciation. As it can be seen, the unweighted averages for the sector and each group are quite close to each other, meaning that pension funds invest similar proportions of their portfolio in currency derivatives. For the 25% depreciation, the liquidity needs are the highest for group 3 funds, 6%, and lowest for group 2 funds. In case of both depreciation shocks, there are very few funds that do not face liquidity needs, 47 funds for 12,5% depreciation and only 31 for 25% depreciation.

Figure 11 depicts the distribution of the liquidity needs generated by the currency

derivatives after a 25% depreciation. Group 2 is distributed across all intervals meaning that group 2 funds face heterogeneous liquidity needs. Group 4 funds are also distributed

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Liquidity Needs 12,5% Depreciation No.

Liquidity Needs 25% Depreciation

No.

T3

None

0/29

1,46%

1/29

T2

-0,40%

3/181

-2,52%

15/181

Table 9- Liquidity Needs as % of Assets after Funds Enter Repo Contracts

across more intervals, meaning that some group 4 funds invest more in currency derivatives. The frequency distribution of liquidity needs for all groups shows little concentration in one interval.

Figure 11- Distribution of Currency Liquidity Needs for a 25% Depreciation

As in section 4.1, the next step in the analysis is to check if pension funds can cover liquidity needs by entering repo agreements. Table 9 Presents the liquidity needs of pension funds after using their AAA-rated government bonds to generate money

temporarily. The table shows that 3 pension funds still have liquidity needs as a result of a 12,5% depreciation, all of them being group 2 funds. In the case of a 25% depreciation, there are 15 pension funds with liquidity needs from group 2 and one from group 3. The average liquidity needs for the 12,5% depreciation are reduced, -0,40%. At the same time, the liquidity needs for the 25% depreciation require funds to sell even more assets.

Table 10 presents how many assets the funds with liquidity needs have to sell after

entering the repo market. Selling the remaining AAA bonds, which are corporate, 2 funds face liquidity needs after a 12,5% depreciation and 5 funds face liquidity needs after a 25%

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Table 10- Liquidity Needs Pension Funds Face After Selling Bonds of all Ratings

Liquidity Needs 12,5% Depreciation No. Liquidity Needs 25% Depreciation After Selling AAA corporate Bonds -0,50% 2 -3,97% 5 After Selling AA Gov. and Corporate Bonds none 0 3,46% 2 After Selling BBB Gov. and Corporate Bonds none 0 -1,12% 1 After Selling A Gov. and Corporate Bonds none 0 none 0

All numbers in this table are for pension funds belonging to group 2

depreciation, all from group 2. These funds need to sell lower rated bonds, both

government and corporate bonds. By doing so, all funds that faced liquidity needs after a 12,5% depreciation are able to cover variation margin calls. However, after a 25%

depreciation, 2 funds still have liquidity needs. These funds can cover liquidity needs if they sell BBB rated bonds. The table shows how after selling each category of bonds, the

number of funds in need of cash decreases, as well as how much money as a percentage of total assets they need. Overall, pension funds have resilience in case the currency

depreciates. There are, however, some funds that need to sell assets and 1 fund will have to sell BBB bonds in order to cover needs.

4.3 Combined Shocks

Economic theory predicts that if interest rates in a country increase, there is more demand for deposits in that country and therefore for that country’s currency. In order to restore the equilibrium in the currency market, the currency of the country where interest rates rose has to appreciate. This section ignores this economic insight and assumes that the currency can depreciate in the same time as interest rates rise. The reason is that the scope of this part of the analysis is to create a stress test in order to check the resilience of the pension funds to extreme market outcomes. Section 4.4 is dedicated to the discussion whether these outcomes are probable. If one assumes that an increase in interest rates can be accompanied by a depreciation of the currency, then these combined market shocks would lead to margin calls from both types of derivatives. This section will calculate liquidity needs generated from currency derivatives under the extreme scenario of a 25% depreciation in the currency. Then, it will be assumed that the depreciation in the currency is accompanied by a 1% increase in interest rates. This means that liquidity needs from section 4.1 can be added to the liquidity needs from section 4.2. Then the process of selling assets can be done again to check if this extra shock puts further pressures on pension funds.

Table 11 presents liquidity needs when both shocks occur at the same time. The first column presents the margin calls from currency derivatives added to margin calls from the

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If both a depreciation and an increase in the interest rate occur, the liquidity needs that result are presented in columns 1 and 2.

Derivative&Currency liquidity needs No. Swap&Currency liquidity needs No. Sector average -14,41% 200/215 -8,91% 195/215

T4 -16,20% 5/5 -9,09% 5/5

T3 -16,08% 28/29 -9,18% 28/29

T2 -14,06% 167/181 -8,85% 162/181

derivative and corrected for cash holdings. Column 2 presents margin calls generated from swaps added to currency margin calls and corrected for cash. The liquidity needs in both columns are high, as expected, since liquidity needs from currency derivatives in section 4.2 should be added up to the liquidity needs calculated in 4.1. For the whole sector, liquidity needs reach 14,4% if we consider the whole derivative portfolio and 8,91% if we only consider swaps. For group 4, liquidity needs are very high when looking at derivatives, reaching 16.2%. For swaps, they reach 9,09%. Group 3 has similar numbers, 16.08% and 9.18% respectively. Group 2 has lower values, comparable with the sector average.

Table 11- Liquidity Needs for Both Depreciation 25% and Interest Rate Increase +1%

In addition to these averages, the paper also looks at the distribution of liquidity needs across each group. As can be seen from figure 12, liquidity needs for group 4 are distributed in a smaller interval, from -20% to 10%, while those of group 2 are distributed evenly across a larger interval. Group 3 funds have liquidity needs on the higher end of the interval, signifying that they are relatively more exposed shocks.

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Figure 12-Frequency Distribution of Derivatives + Currency derivatives Liquidity Needs

The image looks similar for swap liquidity needs as well: figure 13 shows that group 4 funds have liquidity needs that range in a small interval, from -12% to -5%, while group 3

and 2 liquidity needs are distributed in wider intervals. At the same time group 2 funds

have many funds in the extreme end of the interval, ranging from -25% to -15%, while groups 3&4 are better positioned. Overall, Groups 3 and 4 have liquidity needs of moderate sizes and it is in group 2 that funds experience difficulties.

Figure 13- Frequency Distribution of Swap + Currency Derivatives Liquidity Needs

After looking the new liquidity needs under combined risk factors, this section starts the same procedure as in section 4.1. Table 12 shows at the situation in which funds enter the repo market and how much liquidity needs are reduced. It can be seen that they decrease considerably for the whole sector, both in the case of derivatives and swaps, reaching 3.82% and 1.01%. The group 4 funds continue to have high values, reaching 11.41% for derivatives and 3.51% for swaps. Group 3 registers the lowest value, of 2.5% and 0.25%. Group 2 has slightly higher values that the sector averages, reaching 4.04% and 1.15%. Overall, after entering the repo contracts, 93 funds still have liquidity needs

resulting from derivatives& currency margin calls, and only 53 have liquidity needs from swaps & currency margin calls.