The paper opens by showing how certain types of hedge funds can reduce the risk and increase the return on a traditional balanced managed fund. One of the key characteristics of such a hedge fund is that it has a low correlation with the balanced managed fund. The paper puts forward a new way of explaining correlation so that it can be more readily understood, and suggests methods of analysis for dealing with the fact that correlation is unstable. Volatility correlation is also examined because of its importance in reducing the risk of a portfolio.

An outline of the characteristics and risks of three types of hedge funds, namely, long/short equity, convertible arbitrage and merger arbitrage, together with some questions investors might put to prospective hedge fund managers is given in Section 5.

Some of the very basic statistical analysis techniques used in assessing the past performance of hedge funds are given in Section 6. Considerable emphasis is put on the need to examine daily return data as an insight into the quality of the manager's IT systems, his risk management, evidence of smoothing of returns, and to gain access to a higher number of data points for assessing the repeatability of performance.

An entire section of the paper is devoted to gaining a clear understanding of a prospective hedge fund manager's volatility management strategy because of its importance in the context of the fee structure of hedge funds and its importance for assessing the ability of a hedge fund to reduce the risk and increase the returns of a balanced managed fund.

Funds of hedge funds are examined in the final section, and the section concludes that large sophisticated institutional investors may wish to create a portfolio of hedge funds rather than invest in a fund of hedge funds.

In recent years there has been a trend towards market consistent valuation in those institutions for which actuaries have responsibilities. The larger United Kingdom with-profits insurance companies are now preparing realistic balance sheets, both for internal purposes and also at the request of the Financial Services Authority. International accounting standards have been moving to a fair value approach. Pension fund accounting under FRS 17 has also moved in this direction.

In this paper we examine the reasons for the adoption of market consistent valuation and discuss some of the commercial implications and corporate valuation. We consider the methods and assumptions which can be used to develop market consistent valuations of cash flows typically encountered in the liabilities of financial institutions, together with some of the problems inherent in the calibration of models used for the valuation of these cash flows. The volatility assumption is crucial to the valuation of options and guarantees, and we discuss the relationship between historical and implied volatility.

While most insurance companies initially adopted formulae to value their with-profits guarantees, several offices are now using a Monte Carlo simulation approach for their realistic balance sheets. The Monte Carlo approach enables allowance to be made for management discretion in bonus and investment policy, as well as policyholder actions. However, in many cases it is possible to develop analytical formulae for cash flows approximating those payable under insurance contracts.

The valuation formulae have implications for the hedging of embedded guarantees. The authors discuss the construction of hedges for financial risks in with-profits funds, the separate perspectives of policyholders and shareholders, possible funds in which to hold hedging instruments, limitations of capital market hedging tools and the effect of taxation on hedge effectiveness.

This paper considers the market or economic valuation and the hedging of Limited Price Indexed (LPI) liabilities. This involves finding optimal static and dynamic hedging strategies which minimise the riskiness of the investment portfolio relative to the liability.

In this paper we do not aim to find the perfect hedge in a perfect world. Instead, it is assumed that optimisation is restricted to three commonly used asset classes in pension funds: cash; long-term (or irredeemable) fixed-interest bonds; and long-dated index-linked bonds. The economic value of the liability is then defined as the value of the best matching portfolio using a mean/variance type of loss function. Specifically, we adopt the risk minimising approach of Föllmer & Sondermann (1986) and Schweizer & Föllmer (1988). Even with such a simple loss function, establishing the theoretically optimal solution can be difficult. We propose that a practical solution close to the theoretical optimum can be found using two approximations. First, we approximate the ‘true’ stochastic economic model by a vector autoregressive model of order one. Second, we use a sequence of linearisations to approximate non-linear by straightforward quadratic minimisation problems.

The proposed approach is illustrated with various numerical examples, and we compare the results of the approximately optimal hedging strategy with static strategies.