The Use of Derivatives to Hedge Embedded Options : The Case of Pension Institutions in Denmark
The main purpose of this paper is to examine the growing use of derivatives by Danish pension institutions as a risk management tool to hedge embedded options on their balance sheets. Throughout the 1980s and 1990s it was a widespread practice for...
| Main Authors: | , , , |
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| Format: | Policy Research Working Paper |
| Language: | English |
| Published: |
World Bank, Washington, DC
2012
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| Subjects: | |
| Online Access: | http://documents.worldbank.org/curated/en/2007/03/7435986/use-derivatives-hedge-embedded-options-case-pension-institutions-denmark http://hdl.handle.net/10986/7182 |
| Summary: | The main purpose of this paper is to
examine the growing use of derivatives by Danish pension
institutions as a risk management tool to hedge embedded
options on their balance sheets. Throughout the 1980s and
1990s it was a widespread practice for Danish pension
institutions to guarantee a minimum interest rate on new
pension policies. With the new millennium global interest
rates declined steeply and equity markets came crashing
down. Suddenly the guarantees on pension contracts were in
the money. The policies already written could not be
changed, leaving liabilities and assets mismatched, profits
in the red, and capital reserves drained. Out of necessity,
and in some cases virtue, Danish pension institutions turned
in scale to derivatives, allowing for a more active approach
to hedging, asset and liability management, and even profit
generation. Through the use of derivatives, pension
institutions have avoided the need to renegotiate their
guaranteed contracts with policy holders. They have
succeeded as an industry in transforming their pay-off
curves and have emerged with better matched asset/liability
positions and lower exposure to interest rate risk. But the
expanded use of derivatives also raises some risk management
and regulatory issues, such as operational and counterparty
risks as well as effective internal control systems and
regulatory oversight. |
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