Hedging strategies for reducing long-term exposures

Drs. L.F. Wan

As from January 1, 2006, pension funds and insurance companies have to value their outstanding liabilities at market value because of the implementation of the Financial Assessment Frame. Due to the character of their liabilities, this may result in these institutions having to deal with longterm exposures (with interest rate periods of up to 80 years). The question rises whether these exposures could be hedged. In this article the author, working as a consultant for Hewitt Associates B.V., investigates various strategies for hedging longterm exposures with forward and futures contracts. He also looks into the extent to which these strategies link to the current problems of pension funds and insurance companies regarding the interest rate risks as a consequence of the market compatible valuation of outstanding liabilities.

1 Introduction
Hedging is often confused with speculating. It is often wrongly thought that a hedger is taking more risks and is speculating. The following two examples illustrate the difference between hedging and speculating. Example 1: hedging with a forward contract Take the case of a coffee seller who will receive a shipment of coffee over three months and wants to sell this shipment afterwards. This means that the coffee seller runs a risk. After all, the coffee price over three months is still unknown and may increase or decrease during this period. He can decide to enter into a forward contract with a duration of three months. With the forward contract a fixed price is agreed upon for the delivery of the coffee over three months. The delivery price is the current coffee price. This way, the coffee seller is sure that the sales revenue of the coffee over three months is secured. This is an example of a perfect hedge. Example 2: speculating with a forward contract Speculation is the opposite of hedging. A speculator can use a forward contract to make a lot of profit with a small investment. Suppose a speculator thinks the gold price will rise over three months. He can decide to buy the gold now and sell it again after three months if the gold price has risen. However, for this strategy he would have to dispose of a certain amount of cash now. He can also decide to enter into a forward contract with a duration of three months. In that case, he has to buy the gold after three months at the current price. If the gold price has increased in the intervening months, he can sell the gold directly with profit. With this strategy the speculator would hardly need any money to make profit. But of course he runs a much greater risk. After all, if the gold price has decreased after these three months, the speculator will still have to pay the higher price that he agreed upon beforehand. In that case he could lose a lot of money with only a small investment. In short, the purpose of hedging is decreasing the exposures already run. If the end result can be secured, the hedge is perfect. With a perfect hedge the exposures are cancelled out by the applied hedging strategy.

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2 Some important basic definitions

Before discussing various possible hedging strategies, we will introduce a number of important basic definitions by means of an example. Suppose company A has an obligation to deliver oil after10 years. Company A does not dispose of any oil itself. The oil price over 10 years is not known beforehand. This is a financial exposure for the supplier. This uncertainty is taken away by hedging with a forward or futures contract. The oil price in 10 years is, so to speak, fixed at a pre-determined price, the delivery price. In this example the hedge of company A is the oil. The duration of the hedge is 10 years. Forward and futures contracts are contracts which are concluded between two parties. One party is obligated to deliver an asset or merchandise S (the oil in this example) at a pre-determined fixed price. The other party is obligated to buy the merchandise. Company A can decide to already buy the oil now, but in that case it will have to deal with the costs for storage, fire risk, etcetera. These costs are known as the storage cost. Opposite to these costs is the benefit of holding on to the oil, in times of temporary shortage in the oil market or in case of war or extreme cold. This benefit is known as the convenience yield. The cost of carry is the umbrella term for all components that explain the relationship between the price of forward or futures contracts and the spot price, i.e. the oil price in our example. For financial contracts the cost of carry is a norm for the interest revenues less the revenues of the underlying financial asset. This means that e.g. the cost of carry of futures contracts on a stock index is equal to the interest revenues minus the dividend revenues. The cost of carry related to articles of merchandise (gold, silver, coffee, oil, etcetera) is a norm for the interest revenues plus storage costs minus the convenience yield. Hence, the relationship between the stochastic forward price tKT, the stochastic spot price St and the stochastic cost of carry tcT can be expressed as follows:

closed in such a way that the price of the contract upon closure is e 0. Due to the standardized character of a futures contract, the delivery term of the futures may differ from the physical delivery term of the underlying asset S. However, a forward contract is not a standard product and will not be traded in a standard way. As it happens, you will need a counter party that is willing to conclude a forward contract with you. That does not make a forward contract something casual.

3 Difference between forward and futures contracts

The main difference between forward and futures contracts is that settlement with a futures contract takes place on a daily basis, whereas with a forward contract this will not be until the end of the contract. As a result, a perfect hedge by means of futures is not always possible. The daily settlement with futures introduces the terms interest rate exposure and convenience yield exposure. Because of that, it is much more difficult to express the price of futures than that of forwards. We will explain these terms when discussing the hedging strategies. In order to get an overview of the exposures, it is assumed that the interest rate and the convenience yield follow a stochastic process in accordance with the Vasicek model. This means that the interest rate and the convenience yield are divided normally with a long-term average b and a standard deviation s. The futures price tFT is a function of the spot price St, the interest rate rt, the convenience yield yt, and the remaining duration T-t of the risk to be hedged. With a forward plan the futures price can be expressed in a closed formula. However, the different underlying variables make the formula quite complicated.

4 Four generic hedging strategies

There are various hedging strategies. By selecting suitable hedge ratios ht you choose the appropriate hedging strategies. A hedge ratio is a certain position (number) in the forward respectively futures contracts. The selection of suitable ratios takes place through the future cash flows of the hedging strategy. By looking at the total final result by means of the selected hedge ratios and the cash flows generated by the strategy, you can see whether it is possible to generate a perfect hedge. . Usually, however, generating a perfect hedge is not possible. In theory you can find hedge

where t is the current point in time and T is the duration of the forward contract. In the example oil is the underlying asset S of the forward or futures contract. A forward / futures contract is

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ratios which generate a perfect hedge, but these ratios often contain stochastic definitions. This makes reducing the long-term exposures level of the hedge ratios uncertain, which is why estimates are used for the stochastic variable underlying the hedge ratios. These are first based on stochastic interest rates and subsequently enlarged with stochastic convenience yields. The ultimate objective of hedging strategies is generating a perfect hedge. In order to achieve this, you should first identify the risks of the selected strategies. Then you should check whether these risks can be eliminated by adjusting the hedge ratios. If elimination is not possible, the efficiency of the strategy must be determined on the basis of the nature and relevance of the variance in the hedging result. Special attention should be paid to hedging strategies where the hedge is rolled over. This is especially interesting if the maturity date of the hedge is later than the delivery date of all available futures contracts. 1) a single forward contract In the example of the coffee seller we saw that hedging the exposure on a decreasing coffee price by means of a forward contract leads to a perfect hedge. With a single forward contract the exposure is completely eliminated. A necessary condition for the success of this strategy is the availability of another party in the market who is willing to take the opposite position of the hedger, which is not always possible in case of a long-term exposure. Also, a counter party often wants to be financially compensated for the risk to be run. This compensation will be higher as the exposure is longer. 2) roll-over forward strategy For this strategy a perfect hedge can be created under the assumption of stochastic interest rates. By setting the hedge ratios at 1 and combining this with the following borrowing-for-lending strategy a perfect hedge is created: Borrow a sum of money equal to S0 against the fixed interest rate 0rT, for the total hedging period of t = 0 until T. Put the total sum of borrowed money for one period in a savings account at fixed interest rate 0r1 and repeat this for the following periods against the already known fixed interest rates trt+1, t = 1 until the end of the hedging period T-1. The borrowing-for-lending strategy is self funding. Furthermore, there are no payments at the valuation points t = 0, 1, , T1, because all yield is reinvested.
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The spot price exposure is substituted by the interest rate risk. The latter is subsequently eliminated by a correctly selected borrowing-for-lending strategy. The combination of the roll-over forward strategy with the borrowing-for-lending strategy results in a perfect hedge. Both strategies can easily be applied in practice (Note: under the additional assumption of stochastic convenience yields the author did not succeed in constructing a perfect hedging strategy. The stochastic convenience yield risks could not be neutralized as was done with the interest rate exposure. Had there been a certain type of obligation with a longterm rate equal to the convenience yield, it would have been possible to deal with the problem in the same way as the stochastic interest rates. In that case it would have been possible to construct a perfect hedge.). So, the spot price is replaced by the interest rate risk and the convenience yield risk. The first one can be eliminated by using the borrowing-for-lending strategy. To eliminate the convenience yield risk you use forward implied convenience yields, which are implied convenience yields based on familiar convenience yields. The real 1-period convenience yields can be observed from the market as soon as the corresponding period has ended. From this the mismatches between the actual convenience yields and the forward implied convenience yields can be corrected. The result of this adjusted strategy is a forward price with a stochastic (so uncertain) amount of the underlying asset. In other words the result is a forward contract on any amount of the underlying asset, the pseudo-forward contract. An alternative for dealing with the problem is the use of estimations of the convenience yields on the basis of minimum variance. 3) a single futures contract When hedging a futures contract, a forward plan is used. With this strategy you obtain the same end result as with a single forward contract with the delivery of any amount of the underlying asset. What the forward plan is trying to do is finding the amounts in the futures contracts which will reduce the exposure. The end result of the forward plan is similar to that of the pseudo-forward contract. However, it contains many uncertainties with regard to the interest rates and the convenience yields, whereas these have been neutralized at the end result of the pseudoforward contract.

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4) roll-over futures strategy It is assumed that settlement takes place only at the roll-over moments instead of on a daily basis. This assumption is made from a practical point of view. Since in practice transactions costs are charged, daily settlements would become too expensive. That is why settlement, rebalancing and repositioning of futures contracts take place on a monthly basis. For the roll-over futures strategy it is assumed that the 1-monthly futures prices are equal to the 1- monthly forward prices. That way, the same strategy can be followed as with the roll-over forward strategy. The difference with this strategy is the mismatch between de 1-monthly futures price and the 1-monthly forward price. This price mismatch is an additional exposure next to the risks of the roll-over forward strategy already known. Subsequently, the uncertainty of the four hedging strategies is measured by simulating the underlying stochastic processes. For this, for the underlying asset a delivery term of 5 and of 10 years is taken into consideration. The hedging result is then measured on the basis of the simulation results, where the average result and the standard deviation of the hedging strategy is looked at. The ultimate objective, a perfect hedge, is difficult to realize. It is obvious that the risks are not to be ignored.

costs, future mutations in insurance portfolio, etcetera. In case of a hedging strategy, these organizations should therefore investigate the expected hedging result and check which risks still remain or will be added by the hedging strategy selected to reduce the interest rate risk. The outcome of this investigation offer a valuable contribution to the risk management of an insurance company.

About the author

Drs. L.F. Wan works as an actuary with Hewitt Associates B.V., a world-wide HR consultancy firm. Within the framework of his Econometrics study at the Faculty of Economic Sciences and Econometrics at the University of Amsterdam, Mr. Wan wrote a paper entitled Hedging Long-Term Exposures with Forward and Future Contracts. This article is based on the appendix with this paper, in which Mr. Wan discusses the parallel between his research and the current problems with which a lot of pension funds and insurance companies are dealing with regard to the rate risk as a consequence of the market compatible valuation of outstanding liabilities.

5 Conclusion
Currently, there are not enough instruments available in the market to hedge the long-term exposures of pension funds and insurance companies. The question is whether a hedging strategy with interest rate forward and interest rate futures contracts would help reduce the risks. In practice it is very well possible to hedge the risk of a decreasing interest rate with interest rate forward or interest rate futures contracts. The hedging strategy to be selected depends on the need of the insurance company to reduce the interest rate risk. Other hedging instruments and strategies can also be applied, such as matching the duration of the investments to that of the liabilities. However, given the duration of the liabilities of these organizations the question rises if, in theory, duration matching could be used to generate a perfect hedge. In practice, it will be more complicated to realize this, because these organizations - apart from the interest rate risk - deal with other uncertainties, such as mortality rates c.q. longevity risk,

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