This also helps explain the role of equities across the efficient frontier. Equities, in addition to their higher expected returns, provide for a long-term inflation hedge. When the additional diversification benefits of equities are considered, it becomes clear why the addition of equities together with a reduction of the fixed-income duration results in a higher-reward, lower-risk investment strategy.
These results may be surprising to those who advocate duration-matching strategies as a way to minimize risk. Duration matching is predicated on the fact that interest rate sensitivity is the major source of economic risk. This is true for many financial instruments such as bonds where the future cash flows are fixed and certain. The liability characteristics of DFAIC, however, are anything but fixed and certain. Instead they are subject to substantial underwriting uncertainty as well as the whims of unexpected inflation. Because of the significant correlation between interest rates and inflation, changes in interest rates will typically be accompanied by changes in inflation rates. Further, higher inflation rates will lead to higher loss payments which will counteract the economic benefit of a higher discount rate. Thus, controlling only the interest rate risk through a duration matching strategy, when liabilities are inflation sensitive, is an ineffective and inappropriate way of controlling financial risk and can lead to an unintended and severe exposure to unexpected inflationzB.
The final issue to explore concerning DFAIC's economic value efficient frontier is the role of tax-exempt investments. As there were no tax statements provided for DFAIC, information concerning their tax position had to be gathered from their statutory filings. Before serious tax planning can occur, we would want additional information concerning DFAIC's tax reserves, net operating loss carryforwards (NOLs) and capital loss carryforwards. For this study, we assumed no operating loss or capital loss carryforwards and we estimated tax reserves to be a constant ratio to calculated statutory reserves.
The traditional approach for determining DFAIC's optimal allocation to tax-exempt investments is to adjust the tax-exempt allocation to the point that equates the regular tax liability to the alternative minimum tax liability under the company's deterministic budgeted forecast. This methodology for tax management planning can lead to an inefficient allocation to tax-exempt securities since it fails to take into consideration the volatility of the company's projected profitability and the changing relationship between taxable and tax-exempt yields over time.
A much more robust approach to determining the optimal tax-exempt allocation for DFAIC can be identified through the use of dynamic financial analysis. The yield relationships between taxable and tax-exempt fixed-income securities were first simulated based on a combination of historical yield analysis and current market conditions. Similarly, DFAIC's operating results were simulated based on their historical loss performance and current business plans. In this way the after-tax investment income penalty that results from holding tax-exempt securities in unprofitable years can be evaluated against the after-tax investment income advantage of holding tax-exempt
z8Inflation sensitivity is a parameter in the Swiss Re FIRM system. Different inflation sensitivity assumptions will result in different efficient investment strategies. It liabilities are assumed to be insensitive to inflation, duration-matching strategies may be more effective at mitigating risk.