Abstract This study provides the first comprehensive analysis of basis risk in mutual funds underlying U.S. variable annuity policies. These popular personal savings and investment products contain long‐term financial guarantees that expose life insurers to extensive systematic market risk. Although hedging these guarantees is critical, hedging performance is impeded by basis risk since the funds themselves cannot be used as hedging instruments. Using historical returns from a large sample of mutual funds and nearly 600 alternative instruments, we show that insurers can substantially reduce their exposure to basis risk—and improve hedging effectiveness—by enhancing their fund mapping process with data analytic methods, by hedging with exchange‐traded funds instead of futures, and by including more index funds in their offerings. Even so, basis risk remains an important factor when assessing the quality of hedging at the fund level.
Li et al. (Sat,) studied this question.