DECOMPOSING AND MANAGING MULTIVARIATE RISKS: THE CASE OF VARIABLE ANNUITIES
Thomas S. Y. Ho and Blessing Mudavanhu
Many investment strategies, particularly in asset-liability management, involve multivariate risks. Asset-liability management strategies in pension, endowments, insurance, banking often confront with complex correlation structure of equity, currency and interest rate risks. This paper proposes a methodology that uses financial engineering to decompose such multivariate risks into linear combinations of their principal risk sources. As a result, the method offers a practical and effective approach to manage these risks. In particular, this paper applies such a method to manage variable annuities.
The market of variable annuities has grown tremendously in recent years and has become a significant part of our capital markets. These equity and interest rate structured products offer a broad range of guarantees, whose risks are typically borne by the insurers’ balance sheets. In this paper, we apply a decomposition methodology to identify the risks of these guarantees. We then discuss the hedging strategies in managing them within the context of an investment process.