THE DEMAND FOR FINANCIAL ASSETS BY THE BRITISH LIFE FUNDS—A REJOINDER
| DOI | http://doi.org/10.1111/j.1468-0084.1975.mp37002008.x |
| Author | T. M. RYAN |
| Date | 01 May 1975 |
| Published date | 01 May 1975 |
THE DEMAND FOR FINANCIAL ASSETS BY THE
BRITISH LIFE FUNDS-A REJOINDER
By T. M. RYAN
The issues raised in Dodds's comment are largely of a methodological nature.
Specifically, he questions whether the portfolio selection behaviour of financial
institutions such as the life assurance companies may be appropriately analysed
by the application of the mean-variance asset demand framework. He advances
the view that financial institutions fall into two categories: 'speculative' and
'safety-first', and that the mean-variance framework is applicable only to the
former while Life Funds belong to the latter. This view is strongly rejected on two
counts.
(j) To view the mean-variance asset demand framework simply as a theory of
speculative behaviour constitutes a gross misinterpretation of the relevant litera-
ture. In the first place, Dodds appears to regard the term 'speculator' as being
synonymous with 'an individual having low risk aversion', and 'safety-first' as
synonymous with 'high risk aversion'. Dodds's distinction between the two
categories of financial institution is thus one of degree, but it is readily apparent
from consulting any standard text on portfolio selection theory' that the mean-
variance framework explicitly allows for every degree of risk aversion from zero to
infinity.
The more conventional meaning of the term 'safety-first' among financial
economists is that the investor sets a predetermined upper limit to the level of risk
(i.e. variance of return) which he is willing to accept.2 Portfolio selection theory
based on this assumption is a very straightforward variant of the standard 'mean-
variance' model. Furthermore, 'safety-first' in this conventional sense must not
be confused with high risk aversion (which is implicit in Dodds's use of the term),
since such an investor can set his upper limit at any level of risk.
Thus Dodds's distinction between 'speculative' and 'safety-first' financial
institutions is rejected as spurious.
(ii) Similarly, his contention that the Life Funds are 'safety-first' investors (i.e.
that they avoid risk by hedging their assets with IiabilitiesDodds's definition)
does not bear close scrutiny. In the first place, the Life Funds' portfolios are sub-
ject to a considerable degree of default risk, especially when one bears in mind that
capital losses on equities and property are more appropriately considered as in-
stances of default risk rather than of capital risk, since there exists no commitment
to redeem such assets at a fixed value at a future point in time.
A judicious mix of long and short dated fixed interest securities would enable
the funds to match known liabilities with assets by mutually offsetting capital and
income risk.3 If, as Dodds suggests, the Life Funds engaged in such immunization,
See for example Smith (1971) ch. 4.
2 See Roy (1952).
For a discussion of such 'immunization' of funds, see Clayton (1965), pp. 73 if.
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