Embedded options and interest rate risk for insurance companies, banks, and other financial institutions

A discussion of the impact of embedded options in financial institution assets and liabilities on interest rate risk is presented. Findings include a decline in both asset and liability durations when embedded options are present and liability duration declines faster. This mismatch between durations reduces equity value as interest rates rise and increases it as they decline. A more sophisticated model is shown which eliminates the duration mismatch but retains a large convexity mismatch; the impact is strongest and most complex when maturities are roughly intermediate