Robust Long-Term Interest Rate Risk Hedging in Incomplete Bond Markets
29 Pages Posted: 14 Feb 2015
Date Written: August 4, 2014
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: Suggested Citation