Associate Professor Sven Klingler from the Department of Finance at BI Norwegian Business School.
The research sheds important light on pension funds’ exposure to liquidity risks due to their use of derivatives contracts to hedge against interest rate risk.
“In simple terms, when interest rates rise, the value of derivative positions decline, necessitating pension funds to post additional cash as collateral. This leads many of them to sell assets from their portfolios. If they are forced to sell, they can get an unfavourable price and therefore lose money,” Klingler explains.
This can lead to losses for the individuals depending on these funds for their retirement. Notably, these findings contrast traditional views regarding the stability of pension funds as long-term investments.
The research also flags gaps in current regulatory frameworks and prompts regulators to consider the liquidity risks associated with hedging mechanisms.
Not an easy fix
Addressing such liquidity risks is not a straightforward task. Remedial measures could include abstaining from hedging these risks or holding more cash reserves. However, both options come with their own downsides - the former could escalate the risk and the latter could potentially diminish the portfolio's expected returns.
“This is important research both pension funds and regulators should take note of. Sven and his co-authors show that current regulation put in place to make defined benefit pension fund safer together with standard collateral requirements for interest rate swaps expose pension funds to significant liquidity risk. The findings could hopefully pave the way for better informed decisions about the management of defined benefit pensions. Total pension assets often exceed the gross domestic product of the funds’ home country—so, research on pensions is extremely important,” says Head of the Department of Finance Øyvind Norli.
Klingler wins the award together with his co-authors Patty Duijm from the Dutch Central Bank, Kristy Jansen from the University of Southern California, and Angelo Ranaldo from the University of St. Gallen.
Read more about the award and see the full study here: https://www.icpmnetwork.com/research/call-for-research/