Hedging Long-Term Liabilities
49 Pages Posted: 27 Feb 2016 Last revised: 27 Oct 2019
Date Written: October 24, 9
Pension funds and life insurers face interest rate risk arising from the duration mismatch of their assets and liabilities. With the aim of hedging long-term liabilities, we estimate variations of a Nelson-Siegel model using swap returns with maturities up to 50 years. We consider versions with three and five factors, as well as constant and time-varying factor loadings. We find that we need either five factors, or time-varying factor loadings in the three factor model to accommodate the long end of the yield curve. The resulting factor hedge portfolios perform poorly due to strong multicollinearity of the factor loadings in the long end, and are easily beaten by a robust, near MSE-optimal, hedging strategy that concentrates its weight on the longest available liquid bond.
Keywords: Factor Models, Risk Management, Term Structure
JEL Classification: G12, C32, C53, C58
Suggested Citation: Suggested Citation