On the Equity and Interest Rate Predictability for Balanced Portfolios and Coverage Ratios for Pension Plans
20 Pages Posted: 17 Oct 2011
Date Written: October 17, 2011
The purpose of this study is twofold. On one hand we derive an optimal allocation framework between stocks and bonds, with and without a momentum factor, taking into account a regime-switching model based on monthly equity and interest rate data since 1870. On the other, we investigate the optimal portfolio construction for the manager of a pension plan, where the pension’s liabilities are valued in present value terms. Assuming such a pension plan is exposed to two risk factors only, an equity factor and an interest rate factor, the manager needs to decide on the exposure to equities (the beta to equities measured at the level of the total portfolio), and the level of exposure to interest rates, relative to the benchmark defined by the liabilities. Using over 140 years of monthly data pertaining to US equities and 10-year yields, I show that combining a momentum factor with a Markov regime switching approach provides a very robust framework with optimal allocations to stocks and bonds in each regime for the traditional manager, and a well defined equities (beta) exposure and interest rate hedge policy for the manager of the pension plan.
Keywords: Regime Switching, Markov Chain, Strategic and Tactical Asset Allocation, Momentum, Coverage Ratio, Efficient Frontier
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation