Hedging Long-Term Liabilities with a Nelson-Siegel Model
42 Pages Posted: 27 Feb 2016 Last revised: 17 Oct 2018
Date Written: October 11, 2018
We consider the interest rate risk arising from the duration mismatch of the assets and liabilities of pension funds and life insurers. For this purpose we estimate a Nelson-Siegel model on excess bond returns using swap data with maturities up to 50 years. We model time-variation in the Nelson-Siegel shape parameter following the methodology of score driven models. Time-varying factor loadings are important for understanding the behavior of long-term rates after 2008. Whereas the very long end was merely a level factor up to 2008, slope and curvature have become much more prominent in recent years. Based on our estimates a robust, and near optimal, hedging strategy is a simple portfolio of just investing in the longest available liquid bond. The time-varying factor structure implies that hedging errors will be larger in periods when slope and curvature factors are important at the very long end.
Keywords: Factor Models, Risk Management, Term Structure
JEL Classification: G12, C32, C53, C58
Suggested Citation: Suggested Citation