Optimal Investment with Stochastic Interest Rates and Ambiguity

This paper studies the optimal dynamic asset allocation between bonds, stocks, and cash of an ambiguity averse investor. Ambiguity aversion possibly leads to non-participation in the stock market, while the investor always invests in bonds to hedge interest rate risk. The bond-stock ratio increases in the investor’s risk aversion whenever it is well-defined; otherwise, the dependence of the relative investment in bonds to stocks on the investor’s risk aversion depends on the magnitude of ambiguity and the hedging demand. An application to the US market yields an investment in stocks for speculative reasons and an investment in bonds solely for hedging purposes with a bond-stock ratio increasing in the investor’s risk aversion. Quantitatively, ambiguity aversion leads to less leveraged portfolios and a shift to a large fraction of wealth held in cash towards the investor’s time horizon.