Why do many LDI-facing pension plans make use of interest rate derivatives? In many cases sponsors seek to close any gaps in interest rate exposures between an asset portfolio lacking sufficient capital to hedge and the plan’s liabilities. However, many plan sponsors are less comfortable entering into equity-based derivatives, since the higher volatility of the asset class raises concerns around the risk level of such instruments.
This approach makes little sense in the context of a total portfolio. There’s scarce difference between a portfolio that extends its duration via derivatives and holds physical equities and one that holds long-duration physical bonds and achieves equity exposure via derivatives. In this paper we’ll explore why this is and how sponsors who internalize this logic can potentially gain advantages in their LDI endeavors.