Optimal Hedging Strategies for Multi-Period Guarantees in the Presence of Transaction Costs: A Stochastic Programming Approach

European Journal of Operational Research, Vol. 185, No. 3, pp. 1680-1689, 2008

17 Pages Posted: 3 May 2006 Last revised: 27 Jan 2012

Stein-Erik Fleten

Norwegian University of Science and Technology (NTNU)

Snorre Lindset

Norwegian University of Science and Technology (NTNU)

Date Written: April 7, 2006

Abstract

Multi-period guarantees are often embedded in life insurance contracts. In this paper we consider the problem of hedging these multi-period guarantees in the presence of transaction costs. We derive the hedging strategies for the cheapest hedge portfolio for a multi-period guarantee that with certainty makes the insurance company able to meet the obligations from the insurance policies it has issued. We find that by imposing transaction costs, the insurance company reduces the rebalancing of the hedge portfolio. The cost of establishing the hedge portfolio also increases as the transaction cost increases. For the multi-period guarantee there is a rather large rebalancing of the hedge portfolio as we go from one period to the next. By introducing transaction costs we find the size of this rebalancing to be reduced. Transaction costs may therefore be one possible explanation for why we do not see the insurance companies performing a large rebalancing of their investment portfolio at the end of each year.

Keywords: multi-period guarantee, optimal hedging strategies, transaction costs, stochastic programming

JEL Classification: G13, G22, C61

Suggested Citation

Fleten, Stein-Erik and Lindset, Snorre, Optimal Hedging Strategies for Multi-Period Guarantees in the Presence of Transaction Costs: A Stochastic Programming Approach (April 7, 2006). European Journal of Operational Research, Vol. 185, No. 3, pp. 1680-1689, 2008. Available at SSRN: https://ssrn.com/abstract=899281 or http://dx.doi.org/10.2139/ssrn.899281

Stein-Erik Fleten (Contact Author)

Norwegian University of Science and Technology (NTNU) ( email )

NO-7491 Trondheim
Norway

HOME PAGE: http://www.iot.ntnu.no/users/fleten

Snorre Lindset

Norwegian University of Science and Technology (NTNU) ( email )

Trondheim NO-7491
Norway
+4773591395 (Phone)

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