A Penny Saved is a Penny Earned: Less Expensive Zero Coupon Bonds

TL;DR

This paper introduces a novel hedging strategy for zero coupon bonds that requires less initial capital by dynamically adjusting investments between risky securities and fixed income as maturity approaches, challenging traditional risk-neutral approaches.

Contribution

It develops a new hedging method that reduces initial capital requirements and provides a rigorous foundation for investment strategies that favor risky assets early and fixed income later.

Findings

Hedging strategy requires less initial capital than classical methods.

Investments shift from risky securities to fixed income as maturity nears.

Implications for long-term investors and insurers in low interest rate environments.

Abstract

In this paper we show how to hedge a zero coupon bond with a smaller amount of initial capital than required by the classical risk neutral paradigm, whose (trivial) hedging strategy does not suggest to invest in the risky assets. Long dated zero coupon bonds we derive, invest first primarily in risky securities and when approaching more and more the maturity date they increase also more and more the fraction invested in fixed income. The conventional wisdom of financial planners suggesting investor to invest in risky securities when they are young and mostly in fixed income when they approach retirement, is here made rigorous. The paper provides a strong warning for life insurers, pension fund managers and long term investors to take the possibility of less expensive products seriously to avoid the adverse consequences of the low interest rate regimes that many developed economies face.