risk of DFAIC over one-year and five-year time horizons for the current investment s t r a t e g y 27.
Exhibit 6: Decomposition of Economic Risk
Decomposition of Economic Risk
c o "¢= --
Real Underwriting Inflation Discount Rate
As can be seen from Exhibit 6, depends on the time horizon. factors over short time periods.
the impact of the four risk factors on economic risk Neither inflation nor discount rates are significant risk The major risk to DFAIC over a one-year horizon is,
surprisingly, real underwriting uncertainty. The picture changes dramatically when considering a five-year time horizon. Underwriting risk tends to diversify over time whereas inflation risk will tend to accumulate. Thus, inflation uncertainty becomes the biggest risk to the economic well-being of DFAIC over the long term.
This explains why Iow-duralion, fixed-income securities appear as the low-risk investment strategy on the five-year economic efficient frontier. Low-duration, cash equivalent investments tend to move hand-in-hand with inflation, helping to offset the impact of unexpected inflation. Unfortunately, low-duration fixed-income strategies result in tow yields and low expected returns. Thus following a low-risk investment strategy is an expensive way of reducing the economic risk of DFAIC.
2~Underwriting volatility typically includes the impact of inflation but for the purposes of asset strategy it is helpful to separate underwriting volatility into the amount due to inflation and the amount due to loss uncertainty net of inflation. Loss uncertainty net of inflation is assumed independent of asset strategy but loss uncertainty as a result of unexpected inflation is a risk that can be reduced through strategic asset allocation.