Robust Portfolio Choice with Stochastic Interst Rates
40 Pages Posted: 25 Aug 2011 Last revised: 27 Aug 2011
Date Written: June 20, 2011
We determine the optimal investment strategy for an ambiguity averse investor in a setting with stochastic interest rates. The investor is assumed to be ambiguous about the expected rate of return of both bonds and stocks, and may have different levels of ambiguity aversion about the two types of risky assets. We find that it is more important to take model uncertainty about the stock dynamics than the bond dynamics into account. Furthermore, the investor's ambiguity increases his hedging demand. Consequently, the bond/stock ratio increases with his ambiguity. Also, ambiguity implies less trading and less extreme positions in the bank account. Altogether, our model yields portfolio allocations which are more in line with what is implementable in practice. Finally, we demonstrate that neglecting model uncertainty implies significant losses for the investor.
Keywords: Ambiguity aversion, robust portfolio choice, stochastic interest
JEL Classification: D81, G11
Suggested Citation: Suggested Citation