Robust pricing of fixed income securities

In this paper I present closed-form solutions to the intertemporal portfolio allocation problem of a robust investor if she can allocate her wealth among a risk-free asset and a long-term bond.Two setups are examined: in one of my models the short rate follows an Ornstein-Uhlenbeck process (as in the Vašiček-model), while in my other model it follows a CIR process. Besides the implications of robustness for the optimal portfolio allocation, a robust general equilibrium model is also presented which enables me to determine the theoretical value of the equilibrium risk premium. Based on this setup and using detection error probabilities, I calibrate the presented model to U.S. data. I show that introducing robustness is a powerful tool to resolve the bond premium puzzle and the risk aversion parameter required to fit market data is substantially lowered: its value in the non-robust model is y=23, while in the robust model it takes the value y=10.

Netspar, Network for Studies on Pensions, Aging and Retirement, is een denktank en kennisnetwerk. Netspar is gericht op een goed geïnformeerd pensioendebat.


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