Actuarial Finance

20Hedging strategies in practice

Insurance companies, pension plans and investment banks have important liabilities that stem from their main business and that are affected by the variations of many economic and financial variables. For example, life insurance policies and annuities generate liabilities with very long-term maturities and thus are highly exposed to variations in the level of interest rates, among other risks. Similarly, investment banks trade large volumes of options and other financial derivatives whose values are sensitive to the movements of the underlying assets’ prices.

In most situations, these risks cannot be eliminated by simply taking an offsetting position in a similar financial product or derivative. For example:

• An insurance company sells a 15-year EIA based on the S&P 500 index. There are no financial derivatives with such long-term maturities available on exchanges.
• A pension plan will need to pay monthly amounts starting in 15 to 50 years from now but only 15-year and 30-year bonds are available.
• An investment bank sells a 2-year 47-strike call option on ABC inc. However, only calls and puts with maturity 6 months, 1 year and 3 years are available, with strike prices ranging from $48 to $52.

In those cases, the risk manager must set up an investment strategy to mitigate the risks coming from these liabilities.

As opposed to a replication strategy, which is a portfolio reproducing exactly (in all possible scenarios) a given payoff, a hedging ...