Funding Shortfall Risk and Asset Prices in General Equilibrium

Abstract

Institutional investors, such as pensions and insurers, are typically constrained to hold enough wealth to be able to make their contractually promised payments to fund beneficiaries. This creates an additional risk in the economy, namely the risk of funding-shortfall. We seek to explore the optimal asset allocation strategies for institutions facing this risk, and its effects on asset prices. The constraint introduces two distinct regions in the economy, characterising unconstrained and constrained regions, with the possibility of transitioning from the constrained to unconstrained regime, which leads to a two-factor asset pricing model. The funding-shortfall risk increases the conditional equity premium and Sharpe ratio, which evolve counter-cyclically, but decreases the conditional volatility of equity returns, which evolves cyclically. The constrained institution may optimally an under-diversified portfolio, and simultaneously increases its demand for the riskfree and higher-risk assets relative to medium-risk assets, inducing a bubble-like behaviour in the prices of higher-risk assets. The dynamics of contractually promised payments affect the dynamics of conditional moments of asset return distributions, and may lead to predictability. The term structure of interest rates is predominantly upward sloping, but can change shape upon shocks to the growth rate of aggregate dividend relative to the growth rate of minimum payouts. Implied volatility exhibits a time-varying volatility smile, and the term structure of implied volatility can be both upward or downward sloping, depending on the relative growth rates of aggregate dividends and promised institutional payouts. These results may have implications for the design of optimal regulatory requirements.