Mitigating Interest Rate Risk in Variable Annuities: An Analysis of Hedging Effectiveness under Model Risk

Variable annuities are investment vehicles offered by insurance companies that combine a life insurance policy with long-term financial guarantees. These guarantees expose the insurer to market risks, such as volatility and interest rate risks, which can be managed only with a hedging strategy. The objective of this article is to study the effectiveness of dynamic delta-rho hedging strategies for mitigating interest rate risk in variable annuities with either a guaranteed minimum death benefit or guaranteed minimum withdrawal benefit rider. Our analysis centers on three important practical issues: (1) the robustness of delta-rho hedging strategies to model uncertainty, (2) the impact of guarantee features (maturity versus withdrawal benefits) on the performance of the hedging strategy, and (3) the importance of hedging interest rate risk in either a low and stable or rising interest rate environment. Overall, we find that the impact of interest rate risk is equally felt for the two types of products considered, and that interest rate hedges do lead to a significant risk reduction for the insurer, even when the ongoing low interest rate environment is factored in.     

Hedging efficiently under correlation

We show that when a derivative portfolio has different correlated underlyings, hedging using classical greeks (first-order derivatives) is not the best possible choice. We first show how to adjust greeks to take correlation into account and reduce P&L volatility. Then we embed correlation-adjusted greeks in a global hedging strategy that reduces cost of hedging without increasing P&L volatility, by optimization of hedge re-adjustments. The strategy is justified in terms of a balance between transaction costs and risk-aversion, but, unlike more complex proposals from previous literature, it is completely defined by observable parameters, geometrically intuitive, and easy to implement for an arbitrary number of risk factors. We test our findings on a CVA hedging example. We first consider daily re-hedging: in this test, correlation-adjusted greeks allow the reduction of P&L volatility by more than 30% compared to standard deltas. Then we apply our general strategy to a context where a CVA portfolio is exposed to both credit and interest rate risk. The strategy keeps P&L volatility in line with daily standard delta-hedging, but with massive cost-saving: only six rebalances of the illiquid credit hedge are performed, over a period of six months.     

Risk and Market Segmentation in Financial Intermediaries' Returns

This study examines both the quantity and price of risk exposure for different segments of financial intermediaries. Overall, we find evidence of market segmentation in the U.S. financial services industry. Specifically, we find that securities firms, consistently over the sampling period 1974–1994, had the most market risk exposure with the lowest market risk premium. Banks' market risk fluctuated over the sampling period. Banks increased their market risk-taking after the shift in monetary target in October 1979 and the announcement of the risk-based capital requirements in July 1988. The banks' market risk became the highest and insignificantly different from securities firms'. The results are consistent with the moral hazard argument; that is, banks took on more risk to take advantage of government guarantees as their charter value declined. Banks were subject to relatively high interest rate risk premium. However, in response to increased interest rate volatility and decreased charter value after October 1979, banks (while they increased their market risk exposure) lowered their interest rate risk exposure to an insignificant level. The results suggest that the federal safety net may have been perceived by the market as covering only market risk but not interest rate risk. Overall, we find little evidence of interest rate risk exposure, suggesting the prevalence of hedging programs using interest rate derivatives. The interest rate risk premiums, unlike the risk exposure, differ across financial intermediaries.     

Did U.S. and Chinese investors respond differently to the exogenous shocks from COVID-19 and the war in Ukraine?

This paper investigates the U.S. and Chinese stock markets' long-run responses to COVID-19 and the Russia–Ukraine war, the main shocks that have recently battered the globalized economy. The investigation uses both static data analysis and ARMA-GARCH and DCC-GARCH dynamic risk models incorporating both events' impacts. Model fitting reveals opposite reactions of the two stock markets' long-run volatilities to the pandemic, but both volatilities have been enhanced by the war, with a much stronger reaction from the U.S. than from the Chinese market. Furthermore, the war has reduced the linkage between the two markets, while the pandemic has had no significant effect. The different responses of U.S. and Chinese investors may be attributed to the two countries' very different virus containment strategies, pandemic severities, and policy approaches to the geopolitical conflict. Our results have important practical implications for regulators' risk mitigation policy design and investors' cross-market hedging strategy development.     

Interest Rate Risk Management in Major Finnish Firms

The interest rate policies of Finnish firms appear risk aversive, but hedging decisions are influenced by market view. Managers find they can forecast trends in interest rate development, and employ the forecasts in the choice of debt and hedging instruments. The use of risk assessment methods and hedging instruments are related to firm size but not to leverage. Most frequently employed hedging instruments are interest rate swaps and forward rate agreements. The respondents find their firms' interest rate risk management is successful, but performance is seldom measured against an explicitly defined benchmark.     

美国货币政策溢出效应、中国资产价格波动与资本账户管理

本文以2016年美国加息事件为背景,研究美国货币政策对中国资本流动、资产价格和宏观经济的影响。基于小国开放动态随机一般均衡模型,本文梳理了美国货币政策溢出效应的具体传导渠道,发现国外利率升高后,资本流动具有外部性,导致国内资产价格下跌,其通过金融加速器进一步使国内投资下降、资产价格进一步下跌,从而使得国内资产预期回报进一步下降,加剧资本外流。基于政策和福利分析,本文发现资本账户管理可以有效缓解国外利率冲击对经济波动的影响,同时会提高货币政策的独立性,但也会影响国民财富的最优配置。因此,最优的资本账户管理应同时兼顾宏观审慎和效率两个方面。     

Exposure,hedging, and value: New evidence from the U.S. airline industry

For a variety of reasons, the U.S. airline industry is a natural sample to analyze the relation between corporate risk exposure, hedging policy, and firm value. First, we find that airline exposures to fuel prices are higher when fuel prices are high or when they are rising. Second, we analyze the relation between exposure coefficients and the percentage of next year's fuel requirement hedged by airlines. In response to higher fuel price levels, rising fuel prices, and higher levels of exposure to fuel prices, airlines tend to increase their hedging activity. Finally, we explore the previously documented jet fuel hedging premium illustrated in Carter, Rogers, and Simkins (2006). We find a positive hedging premium in our analysis; however, the interaction of hedging and exposure does not affect firm value. We conclude that airlines increasing hedging activity because of higher fuel price exposure are not valued higher compared to those airlines employing more stable hedging policies.     

U.S. monetary policy indicators and international stock returns: 1970-2001

It is documented in the literature that U.S. and many international stock returns series are sensitive to U.S. monetary policy. Using monthly data, this empirical study examines the short-term sensitivity of six international stock indices (the Standard & Poor 500 [S&P] Stock Index, the Morgan Stanley Capital International [MSCI] European Stock Index, the MSCI Pacific Stock Index, and three MSCI country stock indices: Germany, Japan, and the United Kingdom) to two major groups of U.S. monetary policy indicators. These two groups, which have been suggested by recent research to influence stock returns, are based on the U.S. discount rate and the federal funds rate. The first group focuses on two binary variables designed to indicate the stance in monetary policy. The second group of monetary indicators involves the federal funds rate and includes the average federal funds rate, the change in the federal funds rate, and the spread of the federal funds rate to 10-year Treasury note yield. Dividing the sample period (1970-2001) into three monetary operating regimes, we find that not all policy indicators influence international stock returns during all U.S. monetary operating periods or regimes. Our results imply that the operating procedure and/or target vehicle used by the Federal Reserve Board (Fed) influences the efficacy of the policy indicator. We suggest caution in using any monetary policy variable to explain and possibly forecast U.S. and international stock returns in all monetary conditions.     

最优动态汇率风险套期保值模型研究

构建一个最优动态汇率风险套期保值理论模型,并将其套期保值效率与静态策略进行实证对比.采用对角BEKK模型来捕捉货币现货与期货市场的交互影响,从而刻画风险最小化套期比率的动态特征,结果表明,套期保值能减少汇率风险,但具体的套期保值策略的效率高低排序与避险频率相关.     

The open economy consequences of U.S. monetary policy

We consider the open economy consequences of U.S. monetary policy, extending the identification approach of Romer and Romer (2004) and adapting it for use with asset prices. Intended policy changes are orthogonalized against the economy’s expected future path, which captures any effects from open economy variables. Estimated from a set of bilateral VARs, the dynamic responses of the exchange rate, foreign interest rate, and foreign output are consistent with recent work that identifies U.S. policy via futures market changes and a priori impulse response bounds. We compare the two approaches, finding important commonalities. We also outline some advantages of our approach.     

Benefits from Asia-Pacific Mutual Fund Investments with Currency Hedging

This study presents empirical evidence on the efficiency and effectiveness of hedging U.S.-based international mutual funds with an Asia-Pacific investment objective. The case for active currency risk management is examined for a passive and a selective hedge, which is constructed with currency futures in the major currencies. Both static and dynamic hedging models are used to estimate the risk-minimizing hedge ratio. The results show that currency hedging improves the performance of internationally diversified mutual funds. Such hedging is beneficial even when based on prior optimal hedge ratios. Further, efficiency gains from hedging, as measured by the percent change in the Sharpe Index, are greatest under a selective portfolio strategy that is implemented with an optimal constant hedge ratio.     

Oil price shocks and their transmission mechanism in an oil-exporting economy: A VAR analysis informed by a DSGE model

This paper examines the macroeconomic effects of oil price shocks and the oil shock transmission mechanism in an oil-exporting country, Canada. We use a structural VAR with sign restrictions that comes from a two-country dynamic stochastic general equilibrium (DSGE) model to jointly identify oil price, domestic supply and U.S. and domestic monetary policy shocks. This identification strategy not only controls for reverse causality from the Canadian and U.S. macroeconomic conditions to the real oil prices, but more importantly, it also allows for contemporaneous interactions between the Canadian and U.S. variables. We find that oil shocks have a stimulative effect on Canadian aggregate demand, appreciate the Canadian dollar, improve the terms of trade and reduce real wages. Foreign disturbances, including innovations in oil prices and the U.S. interest rate, have a significant influence on Canadian economic activities. Our counterfactual analysis indicates that the reaction of the U.S. interest rate as an indirect transmission channel for oil price shocks plays a moderate role in explaining the real exchange rate and inflation, but has negligible impacts on the Canadian output and interest rate.     

Coberturas financieras con derivados y su incidencia en el valor de mercado en empresas colombianas que cotizan en Bolsa

The financial theory (Modigliani & Miller, 1958) rises that risk management was not an issue for companies because shareholders could make their own hedging management through portfolio diversification; however, further studies conflict with that statement and show that corporate financial hedging improves performance and increases the value thereof (Ahmed, Azevedo, & Guney, 2014; Allayannis & Weston, 2001; Allayannis & Ofek, 1998). Efficient management of market risks, which is based on the use of financial derivatives, demands strategic and efficient managers in hedging that adds value to the firm, especially in against shocks and imbalances from a macroeconomic and financial nature. Empirical evidence analyzes the performance of the Q-Tobin as an indicator of the effect of hedging strategies of exchange rate associated to the market value. This paper aims to find evidence in Colombia on the effect of using derivatives in the market value of the firm. Its added value lies in the analysis made by economic sectors, identified by CIIU codes and grouped into 5 sectors (Agricultural, Commercial, Industrial or Manufacturing, Services and Construction). The methodology includes several models estimating regression panel data, using a Pooled regression with estimators of fixed and random effects by maximum likelihood estimator. In general, it was found a premium due to hedging, statistically and financially significant, for companies exposed to exchange rate risks that use derivatives by an average of 6.3% on the market value. Moreover, mixed results were found regarding the analyzed variables in the model.     

Foreign investment with inflation-linked securities: A natural hedge under Fisher theory?

All foreign holders of U.S. dollars currencies face significant risk of unfavorable currency exchange movements, proportional to the amounts they hold. Some of these risks can be hedged to an extent, but the costs of doing so can be significant, and errors in execution or maintenance of the hedges can cause serious capital losses. Today the vast holdings of China and others creates currency risk on an unprecedented scale. China alone now has a total in excess of a trillion (1 × 10¹²) U.S. dollars, which makes traditional approaches to hedging problematic at best.¹ This paper analyzes the potential hedging effectiveness of investing foreign dollar holdings in U.S. inflation-indexed securities under Fisher's Identity. To the extent that Fisher's Identity and its derivative theories hold, foreign investors can effectively protect the purchasing power of their dollar balances, and earn an assured rate of return. Investment in inflation-indexed securities does not incur the additional expenses that swaps and currency hedges do.     

Information in the Term Structure of Yield Curve Volatility

Using a novel no‐arbitrage model and extensive second‐moment data, we decompose conditional volatility of U.S. Treasury yields into volatilities of short‐rate expectations and term premia. Short‐rate expectations become more volatile than premia before recessions and during asset market distress. Correlation between shocks to premia and shocks to short‐rate expectations is close to zero on average and varies with the monetary policy stance. While Treasuries are nearly unexposed to variance shocks, investors pay a premium for hedging variance risk with derivatives. We illustrate the dynamics of the yield volatility components during and after the financial crisis.     

The economic determinants of interest rate option smiles

We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (€) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.     

Time-varying international diversification and the forward premium

This paper reproduces the slope of the uncovered interest rate parity (UIP) regression for ten country pairs within one standard deviation under rational expectations. We propose an infinite horizon dynamic stochastic general equilibrium model with incomplete markets. Heterogeneous investors experience varying risk aversion as a result of habit formation.The underlying mechanism of the model relies on varying international diversification in the investors' portfolio choice decision. In response to their changing habit levels, investors' hedging desire varies over time. This leads to adjustments in interest rates. The habit-induced investment decisions are negatively correlated with movements in the exchange rate. This results in a negative correlation between interest rates and expected exchange rates, as implied by a negative UIP slope.Depending on the magnitude of habits, the model is capable of reproducing positive as well as negative UIP slopes, as seen empirically in the data.     

SELECTIVE HEDGING OF BANK ASSETS WITH TREASURY BILL FUTURES CONTRACTS

The recent volatility of interest rates, the associated profit pressures imposed on banks, and the surge in the development of new contracts have stimulated a desire to understand and apply financial futures hedging to banking operations. This paper models interest rate futures contracts in a theory of bank behavior to illustrate the hedging of bank loans as well as government securities. The model predicts the hedge will be greater (1) the greater the expected rise in interest rates and (2) the greater the effect of disintermediation on bank deposits. A simulation of the financial futures trading strategy is reported for banks of various asset sizes using data from the Eleventh Federal Reserve District. Depending on bank risk aversion and interest rate expectations, hedging the bank's total interest rate exposure with T-bill futures reduces the variability of unhedged profits by 80 percent.     

The Association Between Market and Exchange Rate Risks and Accounting Variables: A GARCH Model of the Japanese Banking Institutions

This study has two purposes. First, it estimates the market, interest rate, and exchange rate sensitivities (betas) of the Japanese banking institutions. Second, it investigates the relationship between the market-based measures of risk and accounting-based financial ratios. We extend the literature in three important ways. First, we employ a multi-factor GARCH model to estimate the betas. This framework incorporates non-linearities in the bank stock return modeling and allows for time-varying risk premia. Second, we investigate the determinants of market and exchange rate risk in terms of bank financial ratios. To this end, we regress the beta measures derived from the GARCH model against the corporate decision variables to determine the direction and the magnitude of the impact of the latter on the market and exchange rate risk exposures. Third, by using data on the Japanese banking institutions, we provide a comparison of the bank interest rate and exchange rate sensitivities and the strength of the links between the risk measure and the corporate decision variables between the U.S. and the Japanese banking institutions. This comparison sheds light on the robustness of the results concerning interest rate and exchange rate risk, and their determinants, across the two countries. Several interesting results are obtained. First, empirical results indicate that interest rate is only occasionally significant while market and exchange rate variables are significant for all the banks in the sample. Second, market and exchange rate risk measures do impound information in the financial ratios with the explanatory power of the market beta model being higher than that of the exchange rate beta model. Third, the association of the market-based risk measures and the financial ratios is weaker for the Japanese banks than those found for their U.S. counterparts in the existing literature.JEL Classification: G21, F37     

经济危机视角下基于混沌控制的投资风险管理研究

美国的次贷危机引发的全球经济危机,让我们重新审视投资风险管理在金融领域扮演的重要角色,特别对于中国等发展中国家来说,风险管理显得尤为重要,另一方面宏观经济系统普遍存在混沌现象,这种非线性的动力学给予了投资风险管理很大的发展空间,本文在对投资风险管理进行混沌特性分析的基础上,基于房地产市场的投资风险管理进行了混沌控制的实证分析,并对控制变量进行了动态区间分析,最后提出政策建议。