Risk minimizing hedging strategy of variable annuity guarantees under stochastic interest rates
A hedge is an investment position intended to offset potential losses, or in our case to pay off potential liabilities. Interest rates play an important role in hedging strategies and risk management for variable annuities and other long-term products. Financial institutions have an urgent need for practical and affordable dynamic hedging strategies. We propose a realistic interest rates model and the so-called risk minimization hedging strategy. This strategy uses the underlying stock and bond as hedging instruments and minimizes the ongoing costs associated with variable annuity contracts for issuers. The payoff of the target products may have a flexible form, such as single payment at maturity or a sequence of payments. The optimal portfolio will tell the issuers how to construct the hedging portfolio such that they would be able to pay off all liabilities arising from the contracts towards the policyholders. The performance of this risk minimizing strategy will be compared to other dynamic hedging methods, such as delta hedging.