Managing Leverage Risk in LDI Strategies

This diagram illustrates the impact of rising interest rates on a pension fund using LDI (Liability-Driven Investment) strategy with target leverage of 3x.

1. Initial State (Leverage = 3x):

   • Pension liabilities: 600

   • LDI assets: 200 (collateral) × 3 leverage = 600

   • Other return-seeking assets: 400

2. Interest Rate Rise (Leverage = 9x):

   • Pension liabilities decrease to 450 due to higher rates.

   • LDI assets drop to 50 in collateral but still hedge 450 in liabilities → leverage spikes to 9x.

   • Margin call (150) occurs and must be covered using other assets.

3. Post-Rebalancing (Back to Leverage = 3x):

   • Collateral increased by 100 (from other assets), bringing collateral total to 150.

   • Leverage resets to 3x to match the new liability value of 450.

     
     

Key Insight:

Rising interest rates reduce pension liabilities but can lead to liquidity stress and urgent collateral calls if leverage becomes excessive, requiring asset reallocation to stabilize.