Cross-Hedging Minimum Return Guarantees: Basis and Liquidity Risk

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 risk. 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.

Keywords: Basis risk, least-squares Monte Carlo, liquidity risk, margin calls, model risk, periodic premia, variable annuities

JEL Classification: G12, G13