From the blog: Growing up in Shropshire and working in London means the M6 has been a feature of my life for years.
On balance, I have found that I would rather take the M6 toll and be wrong, losing 10 minutes, than take the M6 and be wrong and lose two hours.
This experience is not dissimilar from the decision that many trustees feel they have to make when deciding to implement liability-driven investment.
Since 2003, every time I travel back to Shropshire I have a choice to make as I approach Birmingham: should I take the M6 toll road or not?
While it adds six miles and around 10 minutes to my journey, it provides much greater certainty than the old M6. After doing this for years, the decision has boiled down to one thing – the time of day I am travelling.
I have learnt that the only time to not take the toll is if I am travelling late at night, when I am certain there will be no traffic on the M6. I have learnt from bitter experience that trying to second guess the traffic is a fool’s game.
On balance, I have found that I would rather take the toll and be wrong, losing 10 minutes, than take the M6 and be wrong and lose two hours.
Based on my M6 toll experience I would rather hedge 50% and be wrong than hedge nothing and be wrong
This experience is not dissimilar from the decision that many trustees feel they have to make when deciding to implement liability-driven investment:
Should you hedge and have more certainty about the future funding position but miss out on the opportunity to improve it through liabilities falling?; or
Should you have faith in your view that interest rates can only go in one direction, therefore improving your funding position?
There clearly is no right answer to this question.
Not all-or-nothing
I read with interest 'LDI: Should schemes hedge now or ride it out?'. While I do not disagree with what was said in the article, I think it highlights a misconception with LDI. Crucially, it is not an all-or-nothing decision.
You do not have to choose between either hedging or riding it out.
You do not have to hedge all of your risk (fully lock in current rates) – LDI can be partially implemented in order to balance your views against the risk reduction.
For example, hedging 50 per cent of your risk means that if interest rates fall then you have partial protection – but are still better off than not hedging – and if rates increase then you still benefit, albeit partially, from the rise.
Based on my M6 toll experience I would rather hedge 50 per cent and be wrong – ie see an improvement but not quite as much as if I hadn’t hedged – than hedge nothing and be wrong, and see a significant deterioration in funding position.
Another way to think about risk management is that it is not about implementing your views, it is about managing the risk that your views are wrong.
I learnt this the hard way after years of trusting my judgment on the M6 traffic.
Mark Davies is managing director, derivatives, at River and Mercantile Group
