Inderscience Publishers

A risk analysis of 401k stable value funds


A 401k plan is a defined contribution pension plan provided by employers to employees in the USA. Each plan is established by an employer and allows employees to set aside pre-tax dollars for investment into a basket of securities, typically mutual funds and company stock. One common investment option made available to policy holders are stable value funds (SVF), which invest in high quality fixed income securities and are designed to provide a stable return in excess of money market funds. A key component of stable value funds is a derivative overlay which absorbs fluctuations in the market value of the fixed income portfolio. Investors can trade in and out of the fund at these smoothed levels, which exposes the providers of the derivative overlay to the behavioural risk and decision-making processes of the investors. Using a Monte Carlo based stochastic interest rate model, this paper explores the risk characteristics of these derivatives and proposes a variety of strategies to manage the embedded behavioural and market risks. We also examine the impact of the investors' behavioural risk by introducing simple parametric relationships between investor behaviour and market parameters.

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