Fat Tails and Optimal Liability Driven Portfolios

TL;DR

This paper introduces a new tail risk measure called Extreme Deviation (XD) for optimal liability-driven portfolios, especially in fat-tailed risk environments like pensions and derivatives, emphasizing risk-adjusted returns.

Contribution

It proposes a novel extremal risk measure, XD, and derives optimal portfolio strategies that balance liability hedging with positive risk-adjusted returns in fat-tailed contexts.

Findings

XD is more sensitive to extremal returns than CVaR.

Optimal portfolios combine liability hedging with risk-seeking allocations.

Analysis covers various limits and practical scenarios.

Abstract

We look at optimal liability-driven portfolios in a family of fat-tailed and extremal risk measures, especially in the context of pension fund and insurance fixed cashflow liability profiles, but also those arising in derivatives books such as delta one books or options books in the presence of stochastic volatilities. In the extremal limit, we recover a new tail risk measure, Extreme Deviation (XD), an extremal risk measure significantly more sensitive to extremal returns than CVaR. Resulting optimal portfolios optimize the return per unit of XD, with portfolio weights consisting of a liability hedging contribution, and a risk contribution seeking to generate positive risk-adjusted return. The resulting allocations are analyzed qualitatively and quantitatively in a number of different limits.