liability hedging vs pure matching

[phantom]

how is liability hedging related to pure matching?

 

[Mark Willder]

Many people use the terms hedging and matching interchangeably, but there is a subtle difference between the two.

Liability hedging involves selecting assets whose value moves in the same way as the liabilities.

Matching involves selecting assets which generate the same cashflows as the liabilities.

The fair value of the matching assets will be the same as the fair value of the liabilities (they have the same cashflows), so we can usually say that matching assets are also hedging assets.

However, it is possible to (at least approximately) hedge the liabilities without holding matching assets. For example, a liability to pay in 10 years time could be hedged if we hold zero coupon bonds with terms of 9 and 11 years. The timing of the cashflows is different, so we are not matched. But when we consider the value of the liabilities and assets in one year's time then they should have changed by a similar amount - so we are hedged.

Best wishes

Mark

 

[phantom]

thank you very much.. i have clearer thoughts now.. one more query though:

1. do companies move away from the investments stated in Unit Liked funds? (i.e. mismatch UL liabilities?)
2. will holding assets exactly as reflected in Unit Linked funds (which is what would normally be expected from policyholders) be called liability hedging?

Regards

 

[Mark Willder]

1. do companies move away from the investments stated in Unit Liked funds? (i.e. mismatch UL liabilities?)

In practice it would be very rare to mismatch the unit-linked liabilities. It may be illegal to do so. Even when it is legal, the insurer may be required to hold a large mis-matching reserve which makes mis-matching expensive.

2. will holding assets exactly as reflected in Unit Linked funds (which is what would normally be expected from policyholders) be called liability hedging?

Yes, this is a good example of liability hedging.

Best wishes

Mark