Optimal Investment with Stochastic Interest Rates and Ambiguity

TL;DR

This paper derives a closed-form solution for optimal investment in a market with stochastic interest rates and multiple sources of ambiguity, highlighting how ambiguity aversion influences speculative motives and portfolio strategies.

Contribution

It introduces a model incorporating ambiguity about risk premia, volatilities, and correlation, providing a novel closed-form solution for optimal asset allocation under these conditions.

Findings

Ambiguity affects only the speculative component of investment strategies.

Ambiguity aversion leads to less leveraged portfolios.

The model aligns investment strategies with common financial advice.

Abstract

This paper studies dynamic asset allocation with interest rate risk and several sources of ambiguity. The market consists of a risk-free asset, a zero-coupon bond (both determined by a Vasicek model), and a stock. There is ambiguity about the risk premia, the volatilities, and the correlation. The investor's preferences display both risk aversion and ambiguity aversion. The optimal investment problem admits a closed-form solution. The solution shows that the ambiguity only affects the speculative motives of the investor, representing a hedge against the ambiguity, but not the hedging of interest rate risk. An implementation of the optimal investment strategy shows that ambiguity aversion helps to tame the highly leveraged portfolios neglecting ambiguity and leads to strategies that are more in line with popular investment advice.