The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

ASSET ALLOCATION AND PORTFOLIO CONSTRUCTION DECISIONS IN THE OPTIMAL DESIGN OF THE LIABILITY-HEDGING PORTFOLIO

Risk diversification is only one possible form of risk management, merely focusing at achieving the best risk-return trade-off regardless of investment objectives and constraints. On the other hand, one should recognize that diversification is simply not the appropriate tool when it comes to protecting long-term liability needs.

One key academic insight emanating from the pioneering work of Robert Merton in the 1970s is that the presence of state variables impacting the asset return and/or wealth process will lead to the introduction of dedicated hedging demands, in addition to cash and optimally diversified PSP (which is still needed).

In particular, it clearly appears that the risk factors impacting pension liability values should not be diversified away, but instead should be hedged away. Amongst those, two main risk factors stand out, namely interest rate risk and inflation risk. Although constructing interest rate and inflation hedging benchmarks might seem straightforward compared to constructing performance-seeking benchmarks, some challenges remain, which we discuss now.

Towards the Design of Improved Interest Rate Risk Benchmarks

A first approach to the design of the LHP, called cash-flow matching, involves ensuring a perfect static match between the cash flows from the portfolio of assets and the commitments in the liabilities. Let us assume for example ...