Robust Long-Term Interest Rate Risk Hedging in Incomplete Bond Markets

28 Pages Posted: 5 Aug 2014

See all articles by Sally Shen

Sally Shen

Global Risk Institute; Netspar

Antoon Pelsser

Maastricht University; Netspar

Peter C. Schotman

Maastricht University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: August 4, 2014

Abstract

We introduce a robust investment strategy to hedge long dated liabilities under model misspecification and incomplete bond markets. A robust agent who worries about misspecified bond premia follows a min-max expected shortfall criterion to protect against model uncertainty. We employ a backward least squares Monte Carlo method to solve this dynamic robust optimization problem. We find that both naive and robust optimal portfolios depend on the hedging horizon and current funding ratio. The robust policy suggests to take more risk when the current funding ratio is low. The robust yield curve derived through the minimum assets required to eliminate shortfall risk is lower than the naive one.

Keywords: model misspecification, robust optimization, least squares Monte Carlo, uncertainty set, incomplete market, term structure model

JEL Classification: G11, C61, E43

Suggested Citation

Shen, Sally and Pelsser, Antoon A. J. and Schotman, Peter C., Robust Long-Term Interest Rate Risk Hedging in Incomplete Bond Markets (August 4, 2014). Available at SSRN: https://ssrn.com/abstract=2475797 or http://dx.doi.org/10.2139/ssrn.2475797

Sally Shen (Contact Author)

Global Risk Institute ( email )

55 University Avenue, Suite 1801
Toronto, ON M5J 2H7
Canada

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Antoon A. J. Pelsser

Maastricht University ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands

HOME PAGE: http://https://sites.google.com/site/apelsseraca/

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Peter C. Schotman

Maastricht University - Department of Finance ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands
+31 43 388 3862 (Phone)
+31 43 388 4875 (Fax)

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