Hedging Long-Term Liabilities*

Pricing the Term Structure with Linear Regressions

Rogier Quaedvlieg and Peter Schotman

Journal of Financial Econometrics, 2022, vol. 20, issue 3, 505-538

Abstract: Pension funds and life insurers face interest rate risk arising from the duration mismatch of their assets and liabilities. With the aim of hedging long-term liabilities, we estimate variations of a Nelson–Siegel model using swap returns with maturities up to 50 years. We consider versions with three and five factors, as well as constant and time-varying factor loadings. We find that we need either five factors or time-varying factor loadings in the three-factor model to accommodate the long end of the yield curve. The resulting factor hedge portfolios perform poorly due to strong multicollinearity of the factor loadings in the long end, and are easily beaten by a robust, near Mean-Squared-Error- optimal, hedging strategy that concentrates its weight on the longest available liquid bond.

Keywords: factor models; risk management; term structure (search for similar items in EconPapers)
JEL-codes: C32 C53 C58 G12 (search for similar items in EconPapers)
Date: 2022
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