Robust Asset-Liability Management

2023-10-01

AI Summary

Financial institutions face persistent challenges in hedging interest rate risk for long-term asset–liability mismatches. Method: This paper proposes a bond portfolio construction framework grounded in ambiguity-averse preferences, systematically integrating such preferences into asset–liability management (ALM). The approach accommodates arbitrary liability structures, investment constraints, and interest rate shocks, extending classical immunization theory. Uncertainty is modeled via fuzzy sets; portfolio optimization employs generalized least squares under an arbitrage-free term structure model, inducing implicit regularization that curbs leverage and enhances out-of-sample robustness. Contribution/Results: Numerical experiments and empirical yield curve analyses demonstrate that the proposed method achieves superior hedging accuracy, computational efficiency, and robustness across multiple scenarios compared to existing approaches. The model is transparent, interpretable, and readily implementable in practice.

Abstract

How should financial institutions hedge their balance sheets against interest rate risk when managing long-term assets and liabilities? We address this question by proposing a bond portfolio solution based on ambiguity-averse preferences, which generalizes classical immunization and accommodates arbitrary liability structures, portfolio constraints, and interest rate perturbations. In a further extension, we show that the optimal portfolio can be computed as a simple generalized least squares problem, making the solution both transparent and computationally efficient. The resulting portfolio also reduces leverage by implicitly regularizing the portfolio weights, which enhances out-of-sample performance. Numerical evaluations using both empirical and simulated yield curves from a no-arbitrage term structure model support the feasibility and accuracy of our approach relative to existing methods.

Problem

• Hedging balance sheets against interest rate risk
• Generalizing classical immunization for arbitrary liabilities
• Computing optimal portfolios via efficient least squares

Innovation

• Ambiguity-averse bond portfolio for risk hedging
• Generalized least squares for optimal portfolio computation
• Implicit regularization reduces leverage and improves performance