Asset and liability management: a stochastic model for portfolio selection

The funds management problem involves the allocation of monies to a portfolio that provides cash flows sufficient to meet future liabilities. Such a portfolio should be structured to minimize the cost of funding cash outflow requirements such as claims by insurance policy holders, or benefits owed pension plan beneficiaries. In a world of simple fixed-income securities and stable interest rates the problem is straight forward and can be solved using any number of tools. However, recent growth in the number and types of securities with interest rate sensitive cash flows necessitates the use of decision tools that incorporate uncertainty and an appropriate measure of portfolio risk. The stochastic portfolio selection model proposed in the paper provides such a tool for asset allocation. The proposed model reverses the ordering of the simulation scenario analysis and optimization from most stochastic portfolio selection models currently being utilized for funds management and employs an iterative technique to derive a cost effective portfolio plan