Robustness of bond portfolio optimisation

Pillay, Divanisha

Robustness of bond portfolio optimisation

Master Thesis

2016

Publisher

University of Cape Town

Department

Division of Actuarial Science

Faculty

Faculty of Commerce

Abstract

Korn and Koziol (2006) apply the Markowitz (1952) mean-variance framework to bond portfolio selection by proposing the use of term structure models to estimate the time-varying moments of bond returns. Duffee (2002) introduces a distinction between completely affine and essentially affine term structure models. A completely affine model uses a market price of risk specification that is proportional to the volatility of the risk factors. However, this assumption of proportionality of the market price of risk contradicts the observed behaviour of bond returns. In response, Duffee (2002) introduces a more flexible essentially affine market price of risk specification by breaking the strict proportionality of the completely affine specification. Essentially affine models better represent the empirical features of bond returns whilst preserving the tractability of completely affine models. However, Duffee and Stanton (2012) find that the increased flexibility of the essentially affine model comes at the expense of real-world parameter estimation. Given these parameter estimation issues, this dissertation investigates whether the difficulty in estimating an essentially affine specification is outweighed by the empirical preferability, and whether, all these issues considered, the Markowitz (1952) approach to bond portfolio optimisation is robust. The results indicate that the superior capability of an essentially affine model to forecast expected returns outweighs real-world parameter estimation issues; and that the estimation and mean-variance optimisation procedures are worthwhile.

Keywords

Mathematical Finance

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