Hedging Long-Term Liabilities with a Nelson-Siegel Model

42 Pages Posted: 27 Feb 2016 Last revised: 17 Oct 2018

See all articles by Rogier Quaedvlieg

Rogier Quaedvlieg

Erasmus University Rotterdam (EUR) - Department of Business Economics

Peter C. Schotman

Maastricht University - Department of Finance

Date Written: October 11, 2018

Abstract

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

Quaedvlieg, Rogier and Schotman, Peter C., Hedging Long-Term Liabilities with a Nelson-Siegel Model (October 11, 2018). Available at SSRN: https://ssrn.com/abstract=2737966 or http://dx.doi.org/10.2139/ssrn.2737966

Rogier Quaedvlieg (Contact Author)

Erasmus University Rotterdam (EUR) - Department of Business Economics ( email )

Netherlands

Peter C. Schotman

Maastricht University - Department of Finance ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands
+31 43 388 3862 (Phone)
+31 43 388 4875 (Fax)

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