Robust hedging in incomplete markets

We considered a pension fund that needs to hedge uncertain long-term liabilities. We modeled the pension fund as a robust investor facing an incomplete market and fearing model uncertainty for the evolution of its liabilities. The robust agent is assumed to minimize the shortfall between the assets...

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Bibliographic Details
Published in:Journal of pension economics & finance 2019-07, Vol.18 (3), p.473-493
Main Authors: SHEN, SALLY, PELSSER, ANTOON, SCHOTMAN, PETER
Format: Article
Language:English
Subjects:
Asset allocation
Assets
Balance sheets
Control theory
Discount rates
Economic models
Endogenous
Equity
Funding
Hedging
International finance
Investments
Investors
Liability
Markets
Mortality
Optimization
Pension funds
Pension plans
Robustness
Securities markets
Solvency
Standard deviation
Uncertainty
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Summary:We considered a pension fund that needs to hedge uncertain long-term liabilities. We modeled the pension fund as a robust investor facing an incomplete market and fearing model uncertainty for the evolution of its liabilities. The robust agent is assumed to minimize the shortfall between the assets and liabilities under an endogenous worst-case scenario by means of solving a min–max robust optimization problem. When the funding ratio is low, robustness reduces the demand for risky assets. However, cherishing the hope of covering the liabilities, a substantial risk exposure is still optimal. A longer investment horizon or a higher funding ratio weakens the investor's fear of model misspecification. If the expected equity return is overestimated, the initial capital requirement for hedging can be decreased by following the robust strategy.
ISSN:1474-7472
1475-3022
DOI:10.1017/S1474747218000069