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Cross-hedging minimum return guarantees: Basis and liquidity risks

Author

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  • Ankirchner, Stefan
  • Schneider, Judith C.
  • Schweizer, Nikolaus

Abstract

We reveal pitfalls in the hedging of insurance contracts with a minimum return guarantee on the underlying investment, e.g. an external mutual fund. We analyze basis risk entailed by hedging the guarantee with a dynamic portfolio of proxy assets for the funds. We also take account of liquidity risk which arises since the insurer may need to advance funds for performing the hedge. Based on a least-squares Monte Carlo simulation, we study the economic implications of basis and liquidity risks. We demonstrate that both risks may be surprisingly high and show how the design of the contract and the hedging strategy may help to alleviate them.

Suggested Citation

  • Ankirchner, Stefan & Schneider, Judith C. & Schweizer, Nikolaus, 2014. "Cross-hedging minimum return guarantees: Basis and liquidity risks," Journal of Economic Dynamics and Control, Elsevier, vol. 41(C), pages 93-109.
    • Handle: RePEc:eee:dyncon:v:41:y:2014:i:c:p:93-109
    DOI: 10.1016/j.jedc.2014.02.010
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    Cited by:

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    2. Alexandre Carbonneau, 2020. "Deep Hedging of Long-Term Financial Derivatives," Papers 2007.15128, arXiv.org.
    3. Bauer Jan, 2020. "Hedging of Variable Annuities under Basis Risk," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 14(2), pages 1-34, July.
    4. Denis-Alexandre Trottier & Frédéric Godin & Emmanuel Hamel, 2018. "On Fund Mapping Regressions Applied to Segregated Funds Hedging Under Regime-Switching Dynamics," Risks, MDPI, vol. 6(3), pages 1-15, August.

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    More about this item

    Keywords

    Basis risk; Least-squares Monte Carlo; Liquidity risk; Periodic premia; Variable annuities;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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