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Robust long-term interest rate risk hedging in incomplete bond markets

Published online by Cambridge University Press:  07 July 2020

Sally Shen ,
Antoon Pelsser  and
Peter Schotman
Sally Shen*
Affiliation:
Global Risk Institute, Toronto, Ontario, Canada Network for Studies on Pensions Aging and Retirement, Tilburg, Noord-Brabant, Netherlands and
Antoon Pelsser
Affiliation:
Maastricht University, Maastricht, Limburg, Netherlands
Peter Schotman
Affiliation:
Maastricht University, Maastricht, Limburg, Netherlands
*
*Corresponding author. Email: [email protected]
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Abstract

Pricing ultra-long-dated pension liabilities under the market-consistent valuation is challenged by the scarcity of the long-term market instruments that match or exceed the terms of pension liabilities. We develop a robust self-financing hedging strategy which adopts a min–max expected shortfall hedging criterion to replicate the long-dated liabilities for agents who fear parameter misspecification. We introduce a backward robust 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 the current funding ratio. The robust policy suggests taking more risk when the current funding ratio is low. The yield curve constructed by the robust dynamic hedging portfolio is always lower than the naive one but is higher than the model-based yield curve in a low-rate environment.

Keywords

Incomplete marketleast squares Monte Carloliability valuationparameter uncertaintyrobust optimizationG11C61E43
Type
Article
Information
Journal of Pension Economics & Finance , Volume 20 , Issue 2 , April 2021 , pp. 273 - 300
Copyright
Copyright © The Author(s), 2020. Published by Cambridge University Press

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