In Search of Habitat
59 Pages Posted: 19 Apr 2012 Last revised: 16 Dec 2013
Date Written: December 2013
We perform portfolio level analysis to trace the preferred habitat investment behavior in the government bond market. With a preferred habitat, investors would have an inelastic demand to bonds at given horizons. This is confirmed by the empirical evidence that the aggregate portfolios of insurance firms exhibit restrained elasticities to interest rate changes. We further investigate two forms of habitat --- a liability habitat driven by the need to immunize the interest rate risk of operating liabilities, and a horizon habitat due to the preference for holding securities with riskfree returns for the investment horizon. Consistent with the two effects, we fnd that insurers' portfolio interest rate risk is strongly related to that of the operating liabilities, and that the size of liability and risk aversion dampen insurers' portfolio response to term structure changes.
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