The Mathematics of Financial Modelingand Investment Management

2-Financial Markets Page 40 Wednesday, February 4, 2004 1:15 PM

40 The Mathematics of Financial Modeling and Investment Management

although sometimes allowable under accounting procedures and regula-

tions, is not sound investment practice.

The economic surplus of any entity is the difference between the mar-

ket value of all its assets and the market value of its liabilities. That is,

Economic surplus = Market value of assets – Market value of liabilities

The market value of the liabilities is simply the present value of the lia-

bilities, where the liabilities are discounted at an appropriate interest rate.

Institutional investors must prepare periodic financial statements.

These financial statements must be prepared in accordance with “gener-

ally accepted accounting principles” (GAAP). Thus, the assets and lia-

bilities reported are based on GAAP accounting and the resulting

surplus is referred to as accounting surplus.

Institutional investors that are regulated at the state or federal levels

must also provide financial reports to regulators based on regulatory

accounting principles (RAP). RAP accounting for a regulated institution

need not use the same rules as set forth in GAAP accounting. Liabilities

may or may not be reported at their present value, depending on the

type of institution and the type of liability. The surplus, as measured

using RAP accounting, is called regulatory surplus or statutory surplus,

and, as in the case of accounting surplus, may be materially different

from economic surplus.

Benchmarks for Nonliability Driven Entities

Thus far, our discussion has focused on institutional investors that face

liabilities. However, not all financial institutions face liabilities. An

investment company (discussed later) is an example. Also, while an

entity such as a pension plan may face liabilities, it may engage external

asset managers and set for those managers an objective that is unrelated

to the pension fund’s liabilities. For such asset managers who do not

face liabilities, the objective is to outperform some client-designated

benchmark. In bond portfolio management, the benchmark may be one

of the bond indexes described in Chapter 21. In general, the perfor-

mance of the money manager will be measured as follows:

Return on the portfolio – Return on the benchmark

Active money management involves creating a portfolio that will

earn a return (after adjusting for risk) greater than the benchmark. In

contrast, a strategy of indexing is one in which an asset manager creates

a portfolio that only seeks to match the return on the benchmark.