Dynamic Asset Allocation Strategy for Intertemporal Pension Fund Management with Time-Varying Volatility

Abstract

In this paper, we examine the optimal dynamic asset allocation strategy in relation to a pension fund with a time-varying investment opportunity set. The sources of changes in the investment opportunity set in our model possess time-varying volatility and risk premia. We deal with the pension fund asset allocation problem, characterized by time-varying volatility, by using Sharpe and Tint’s (1990) liability approach and Merton’s (1993) intertemporal capital asset pricing methodology regarding the optimal investment strategies for university using perturbation methods. In contrast to Merton (1971, 1993), we propose a new liability hedging component in the dynamic asset allocation in addition to the intertemporal hedging component for pension funds in order to hedge against changes in the pension fund liability in our model.