Summary

Pension plans are interested in liability driven investment strategies to hedge the risk that their assets may be insufficient to fulfill their future obligations to pay benefits. In this sense, the LDI strategy is very similar to the immunization strategy we studied in Chapter 2. Traditional portfolio management looks to maximize risk-adjusted returns on the asset side of the balance sheet. Pension management, on the other hand, looks at both sides of the balance sheet, treating liabilities as short positions in conjunction with the plan's long position in assets. Looked at this way, all pensions optimize some type of LDI strategy and, in most cases, it is not an immunization strategy (that is, LDI doesn't necessarily have to hedge all the liabilities and in fact it may not be optimal to do so).

We began this chapter with a discussion of tail risk hedges in the form of put options. These are straightforward hedging strategies that are practical, if priced right, and easy to apply. We also studied variance swaps as an alternative hedge strategy although here we are looking to hedge volatility risk. We would be selling volatility if we thought it was too overpriced. We rounded the discussion out with an introduction to VIX calls. These provided a reasonable introduction on how we might think about hedging portfolio risk and what methods or products may be available. They are not exhaustive and in fact there are new hedging instruments continually invested in markets. I ended with LDI because I wanted to impress upon you that too often investment managers act as agents maximizing asset returns when their principals (for example, trustees) face the objective of managing the short position (liabilities) as well. The point here is that the two objectives are not necessarily the same. For example, maximizing returns on assets may not lead to the liquidity a pension needs, for example, to fund future benefits. The liability side of the balance sheet in this case needs to be formally incorporated into the optimization problem which, we see, is not difficult and indeed gives the problem more flavor.