Work in progress
Robust Hedging of Terminal Wealth under Interest Rate and Inflation Risk, with Anne Balter and Frank de Jong.
Investors often hedge their liabilities against nominal interest rate risk. However, inflation risk also plays an important role for real wealth outcomes, especially in the long-run. If both risks follow a bivariate mean-reverting process, optimal allocations in nominal bond strategies typically turn out to be extreme, in particular when the bond maturities lay close to each other. We show that this makes the investment strategy sensitive to small changes in the mean-reversion parameters and the feedback parameter that takes into account the impact of the inflation rate level on the nominal interest rate drift. We perform a numerical analysis to demonstrate that small estimation errors of these parameters might have a large impact on terminal real wealth. A range of values of the feedback parameter is applied to compare the resulting investment strategies to Brennan and Xia (2002), Van Bilsen et al. (2020), and Munk et al. (2004). We find that the optimal two bond strategies involve one medium term bond and one very long-term bond, but these strategies are very sensitive to parameter uncertainty. One bond strategies are more robust, but cannot completely hedge inflation risk, which results in a large loss in the Certainty Equivalent Wealth of a risk averse investor.
Robust hedging of terminal wealth under interest rate risk with the constraint approach, with Anne Balter and Frank de Jong.
Long-term investors hedge their liabilities against nominal interest rate risk by bond investments. However, the optimal bond allocations are very sensitive for the underlying parameters, so that an investor who ignores parameter uncertainty may face a large loss in utility. Therefore, we consider a robust investor who takes into account parameter uncertainty. We apply the constraint approach to limit the considered entropy around the market price of risk and the mean-reversion. In case of only uncertainty about the market price of risk, we find that if entropy increases the strategy of a speculative investor converges to that of a hedge investor. The investment decision and welfare of a very risk-averse investor is hardly affected, because her ability to hedge terminal wealth remains unaffected. If we additionally allow uncertainty about the mean-reversion, we find state- and horizon-dependent robust bond allocations.
Parameter uncertainty and climate risk – job market paper