Edhec Working Paper the Benefits of Structured Products in Alm

The Benefits of Structured Products in Asset-Liability Management
December 2008

Lionel Martellini

Professor of Finance, EDHEC Business School and Scientific Director, EDHEC-Risk Institute

Vincent Milhau

Research Engineer, EDHEC-Risk Institute

Abstract
This paper introduces a continuous-time dynamic asset allocation model for an investor facing liability constraints in the presence of inflation and interest rate risks. When funding ratio constraints are explicitly accounted for, the optimal policies, for which we obtain analytical expressions, are shown to extend standard Option-Based Portfolio Insurance (OBPI) strategies to a relative risk context, with the liability-hedging portfolio replacing the risk-free asset. We also show that the introduction of maximum funding ratio targets would allow pension funds to decrease the cost of downside liability risk protection while giving up part of the upside potential beyond levels where marginal utility of wealth (relative to liabilities) is low or almost zero.

This paper is a shortened version of a paper entitled “How Costly is Regulatory Short-Termism for Defined-Benefit Pension Funds?”. This research has benefited from the support of the “Structured Products and Derivative Instruments” research chair supported by the Fédération Bancaire Française. We would like to thank Noël Amenc, Peter Carr, Nicole El Karoui, Samuel Sender, Volker Ziemann, as well as participants at the Bloomberg finance seminar, Bachelier mathematical finance seminar and University of Paris-Dauphine finance seminar for very useful comments. Any remaining error is ours. The “Structured Products and Derivative Instruments” research chair at EDHEC-Risk Institute, in partnership with the French Banking Federation (FBF), investigates the optimal design of structured products in an ALM context and studies structured products and derivatives on relatively illiquid underlying instruments. EDHEC is one of the top five business schools in

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