Robust portfolio choice with stochastic interest rates

Christian Riis Flor, Linda Sandris Larsen

Research output: Contribution to journalJournal articleResearchpeer-review

Abstract

We determine the optimal investment strategy for an ambiguity-averse investor in a setting with stochastic interest rates. The investor has access to stocks, bonds, and a bank account and he is ambiguous about the expected rate of return of both bonds and stocks. The investor can 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 model uncertainty about the bond dynamics into account. Furthermore, the investor's ambiguity increases his hedging demand. Consequently, the bond/stock ratio increases with his ambiguity and implies 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.

Original languageEnglish
JournalAnnals of Finance
Volume10
Issue number2
Pages (from-to)243-265
ISSN1614-2446
DOIs
Publication statusPublished - May 2014

Keywords

  • Ambiguity aversion
  • Model uncertainty
  • Robust control
  • Welfare loss

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