Robust Portfolio Choice with Stochastic Interst Rates

40 Pages Posted: 25 Aug 2011 Last revised: 27 Aug 2011

See all articles by Christian Riis Flor

Christian Riis Flor

University of Southern Denmark

Linda Sandris Larsen

Copenhagen Business School

Date Written: June 20, 2011

Abstract

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

Flor, Christian Riis and Larsen, Linda Sandris, Robust Portfolio Choice with Stochastic Interst Rates (June 20, 2011). Available at SSRN: https://ssrn.com/abstract=1916628 or http://dx.doi.org/10.2139/ssrn.1916628

Christian Riis Flor

University of Southern Denmark ( email )

Campusvej 55
Odense DK-5230
Denmark
+45 6550 3384 (Phone)
+45 6593 0726 (Fax)

HOME PAGE: http://sites.google.com/site/florfinance/Home

Linda Sandris Larsen (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3, A5
Frederiksberg, 2000
Denmark