 Hi guys, it's MJ and in this video, we're going to be looking at asset liability modeling And what I'm going to do in this video is I want to try explain this as simply as possible for you guys It's one of the the techniques that I think actuarial science has was one of the most practical Actuarial techniques and it's really helped people when it comes to investment strategy so when you think asset liability modeling you need to be thinking of investment strategy Okay, how does it help? investment strategy Well, when you talk to people and you say what do you want to invest in? What do you want to get out of it and all these type of things you'll often hear people say? Oh, I want a 10% return and That's that's a fair enough objective. You want a 10% return that that sounds great but Yeah, that's not enough. That's you know, that's looking at investing too simplistically I mean you're only considering the one dimension What asset liability modeling does and we'll get to a little example or an illustration of it But one of its advantages is that it encourages investors to formulate explicit objectives. So Just how you have got that 10% return you want that measurable performance target So we want a measurable performance target which That guy had it. So nothing wrong about that. It's just incomplete Because what the also needed to to put forward is a performance horizon Another way of thinking about this is the duration how long, you know Does he want 10% return annually monthly of the next three years of the next 10 years? You know because and is that real return is it nominal return all these type of things Finally, you also want to have a confidence level Another way of thinking of confidence level is risk. So, I mean we can basically put this in simple English which is return duration and risk Okay, so now how do the actress You know, what was the big breakthrough in investment strategy? What did they do that nobody else or none of the other professions was thinking about and that is that they looked at the liabilities So before someone would come forward and they'd say I've got 10 million rand worth of cash I'm seeking a 10% return I want to minimize my risk invest it go and the investment All the asset manager, you know, we're trying to create a little portfolio Try and diversify it You know, we'll take his fees and so forth like that The actual approach to investment strategy says well, let's consider your assets and your liabilities so we want to look at your assets and Your liabilities and now what we want to do is we want to create a model That models both the assets and the liabilities at the same time So instead of just modeling the assets so before we would just focus on assets now We're going to be focusing on assets and liabilities So when we build our model, we can have it as stochastic or deterministic. Let's go stochastic for this example It's a little bit more fun You're gonna have certain parameters that influence both your assets and your liabilities These are known as your dynamic links. So something such as maybe inflation interest rates Currency currency rates as well could be another one. There's quite a few and what we're gonna assume is that each of these things is a random variable that follows a certain statistical distribution Okay What we also gonna take into consideration is that you have your assets your assets might have some Parameters that only affect them. Let's say if you're buying shares the the value of that share All the price of the property or something like that that will also be a a random variable and Then also with say liabilities, let's say you have a liability that's linked to I don't know You have to pay your Grandmothers or mother-in-laws hospital bill If something happens to her and that's again a random variable because you don't have medical aid or something like that Sorry, I'm just making I'm making this up So but the idea is that when in business you'll have liabilities that will be Influenced by certain parameters assets that will be influenced by certain parameters and then a bunch of parameters that will influence both of them then what you do is You simulate All of these variables. So you put them all in together and You'll run it something like a million times if you have the computer power So a million times you pick. Okay. Maybe the first one we pick one there pick one there pick there they're on their distribution they're on the distribution and It generates a run out of space. So let's put it maybe over here It generates an Answer then you do it again Maybe picks these ones randomly on the curve. This is their probability density functions and It starts doing this you keep doing that and what you do is you plot you end up plotting Say a little distribution So your input is distribution and your output is distribution and Let's say this is your target is to get a return above that amount That will indicate your risk and in the model you would have stated what your duration is and The great thing about this is that you can see Or you can stress test it and do some scenario testing and you can see which Variable is the biggest, you know has the biggest influence as the biggest impact Let's say it turns out inflation has the biggest impact Then what we can do is we can rearrange our assets in such a way that they are immunized against inflation Then do it again and compare our results. So we'll have another one that has maybe got inflation taken care of and This one might have you know Might have a better risk but a worse return and What the act tree will do is they will keep playing around with different different types of assets Putting it in the model and seeing what happens and because of the dynamic links is very difficult to do this without using a model When I mean play around with assets, I mean maybe say 30% in property 10% in bonds 60% in shares Or you might find out that actually doesn't work out at what at all Inflation is quite high Tends to be quite high. Let's rather go with 60% in property because we believe property will be an inflation hedge And let's go 30% Bonds that have got an inflation protection and only 10% in shares something like that and you compare each portfolio that you do will with a Monte Carlo simulation Give a certain distribution Once you have that distribution you can do your confidence intervals You can see okay What is the probability that we meet the criteria that we you know managed to reach our objective? and Maybe what you might find out is maybe this 10% return is unachievable You know you can say well look at this There's only 10 we only hit a 10% return 3% of the time And you can more align investors expectations Also by taking liabilities into consideration You can kind of have a better understanding of risk. So someone will be like I want to minimize risk Well, yeah, everybody wants to do that But what risks do you want to minimize because it's easier to minimize some risks than other risks? Or if you've got more exposure to say market risk It's better to do something that tackles market risk rather than something that's trying to tackle market risk and credit risk at the same time And then you Sacrificing unnecessary return for a risk that you don't have exposure to so the great thing about this Or about this technique and why it's so successful in investment strategy is because it is efficient When it comes to risk and we're gonna look later in the course something called risk budgeting But Joe it's really cool how we're gonna be seeing some actuarial principles coming into finance and Actually helping the the entire investment strategy and this is something that quite a lot of non-actuaries now have also started doing because of its benefits But there we go. That's acid liability modeling in a nutshell Probably later down in the course will do some more in-depth videos around what it is and all that type of stuff But I thought it's important that we have a nice quick little introduction to it But yeah, thanks guys so much for watching and hit subscribe new videos coming out every single day around finance Cheers