The Chinese Pension System
February 12, 2025
The proprietary ratio is not amongst the commonly used ratios. Very few analysts prescribe its usage. This is because in reality it is the inverse of debt ratio. A higher debt ratio would imply a lower proprietary ratio and vice versa. Hence this ratio does not reveal any new information. Formula Proprietary Ratio = Total […]
In the previous articles, we have already seen what Buy Now Pay Later (BNPL) financing is, how it is implemented as well as the advantages of such financing to merchants. The common viewpoint is that corporations only benefit from implementing Buy Now Pay Later (BNPL) financing. This means that even though individuals might associate disadvantages […]
Stripe is one of the most prominent start-ups in the world. It does not have the fame or popularity of other start-ups like Uber or Airbnb. However, Stripe has achieved an equivalent amount of success. In fact, as of early $2022, this start-up company was valued at $95 billion! This stupendous valuation makes it one […]
Definition of Financial Planning Financial Planning is the process of estimating the capital required and determining it’s competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. Objectives of Financial Planning Financial Planning has got many objectives to look forward to: Determining capital requirements- […]
The growth story of Tesla is no ordinary story. It is a testimony to what a start-up can achieve if it’s given an adequate amount of funding and good leadership guidance. It would be wrong to classify Tesla as a start-up company now. Tesla is now one of the most popular automobile companies in the […]
In the previous article, we have already seen how pension funds have been adversely affected by an increasing amount of longevity risk.
The increase in the average lifespan of people is definitely a positive development. However, it has an adverse impact on the financial situation of most pension funds.
In order to mitigate longevity risks, pension funds across the world have started relying on financial innovation. Longevity bonds and longevity derivatives are financial instruments that allow pension funds to transfer the financial risk from the institution to individuals.
The details regarding the functioning of longevity bonds and longevity derivatives have been explained below:
Longevity bonds are a type of financial instrument in which the coupon rate to be paid is not fixed. Instead, the coupon rate to be paid is variable and depends upon the life expectancy of a group of people.
Since the life expectancy of a group is not easy to measure, the issuers of these bonds create an index for this purpose. This value of this index changes based on the demographic data which is being released by the population. At the same time, the value of this index is the basis for coupon payments being made. As the value of the index keeps on increasing, it means that the mortality rate of a given population is also increasing.
If the mortality rate increases, the coupon payments are also correspondingly reduced. This means that there is an inverse correlation between the mortality rate and coupon payments. As the mortality rate keeps increasing, the coupon payments go on reducing. Finally, when there are no members of the demographic group left, the coupon payments go to zero.
It needs to be understood that these bonds actually function as an annuity. This is because the principal amount on these coupon bonds is never returned. Instead, the investor trades a lump sum for a series of small payments.
Longevity derivatives are very similar to longevity bonds. In fact, a lot of the time, longevity derivatives are based on longevity bonds. The concept of longevity derivatives includes all types of instruments viz. forwards, options, and swaps.
Longevity derivatives are still quite unique. Hence, there are traded over the counter and not on an exchange. For example, two parties may swap their cashflows based on the value of the mortality rate in the demographic index.
Now, the question is why would investors and financial institutions want to invest based on the mortality rate. There are several reasons why investors find longevity derivatives to be useful. Some of these reasons have been mentioned below:
For instance, a pension fund may pay a relatively small premium to insure itself against the risk that its customer population will live longer than expected. This will help them match their cash flows to their liabilities and transfer the risks to a third party.
Financial institutions and investors have found the concept of longevity bonds to be appealing to some extent. However, they have not invested large sums of money in this idea. Hence, longevity bonds are still not very prevalent in the market. There are some significant disadvantages related to longevity derivatives. Some of these disadvantages have been mentioned below:
In the absence of a market and standardized pricing mechanisms, it can be very difficult to price such instruments. Therefore, investors can never really be sure if they are buying the instruments at the right price.
The bottom line is that longevity bonds and longevity derivatives are still in the nascent stage. They are very promising when it comes to risk management in pension funds. However, the market is yet to be fully developed.
Your email address will not be published. Required fields are marked *