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Volume 17,     Number 4,     Winter 2009

 

VALUING GUARANTEES ON SPENDING
FUNDED BY ENDOWMENTS
Y. HUANG, P. A. FORSYTH AND K. R. VETZAL

Abstract. Spending commitments by institutions such as colleges and universities or hospitals are frequently funded by endowments which are invested in risky assets. Many institutions use a simple endowment spending policy based on a maximum payout of a fixed fraction of the rolling average endowment value. However, periods of low investment returns on the endowment will reduce the amount available for disbursement. If this amount is less than the committed level of spending, the institution may be forced to make up the difference from other sources. For example, an endowed professorship at a university contains an implicit guarantee of a certain level of spending. If returns on invested capital are insufficient, the university must cover the deficit. To reduce the risk involved, some institutions have adopted a policy of setting aside surplus funds from periods of high returns in a reserve account which can be drawn upon in the event of a shortfall. We investigate the performance of this type of strategy. In particular, we determine the no-arbitrage value of guaranteeing a level of spending funded by an endowment that is invested in risky assets and which has a reserve account. Our results show that the reserve is not a panacea. For typical parameter values, the implied value of the guarantee is quite large.

 

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