Robust Long-Term Interest Rate Risk Hedging in Incomplete Bond Markets

Authors: Sally Shen, Research Analyst, Global Risk Institute, Professor Antoon Pelsser, Dept of Finance, Maastricht University, Professor Peter  Schotman, Dept of Finance, Maastricht University

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Robust Long Term Hedging

Abstract

Due to the scarcity of long-term market instruments, valuation of an ultra long-term pension liability under the market-consistent valuation framework must be model based. We develop a robust self-financing hedging strategy which adopts a min-max expected shortfall hedging criterion to replicate the long dated liability for agents who fear model misspecification. We introduce a backward robust least squares Monte Carlo method to solve this dynamic robust optimization problem. We find that both naive and robust optimal portfolios depend on the hedging horizon and the current funding ratio. The robust policy suggests to take more risk when the current funding ratio is low. The
artificial yield curve constructed by the robust dynamic hedging portfolio is lower than the naive one but is higher than the model based yield curve in a low rate environment.