Pricing Embedded Options In Value-Based Asset Liability Management

Abstract

The classical asset liability management (ALM) approach has a significant role in financial policy decisions of many institutional investors and consultancy firms. Classic ALM analysis focuses on financial position and balance sheet and is based on the probability distributions of key pension fund variables over a certain horizon. Econometric models are used to create projections of economic scenarios. Economic value can be understood as the present financial value of uncertain future cash flows such as it relates to the value of future indexation flows and contributions. The absolute and relative changes of the economic values of the future commitments in the pension deal from a change in the policy parameters reveals the changes in risk positions of the different groups of stakeholders. The return dynamics is based on a vector autoregressive (VAR) model that enables to distinguish long-term and short-term risk properties of asset classes. The ALM framework is based on a simulation study which projects the development of the pension fund in many future scenarios. The policy horizon for the classic ALM analysis is twenty years. The asset returns are used to determine the returns on the asset mix. Interest rates are used to compute the present value of liabilities, and inflation scenarios are employed to index the liabilities.