Model uncertainty in financial markets: Long run risk and parameter uncertainty

F.A. de Roode

Research output: ThesisDoctoral Thesis

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Abstract

Uncertainty surrounding key parameters of financial markets, such as the in-
flation and equity risk premium, constitute a major risk for institutional investors
with long investment horizons.
Hedging the investors’ inflation exposure can be challenging due to the lack
of domestic inflation-linked securities. I show that inflation hedging investors
can benefit from holding bonds that are linked to inflation in foreign countries.
Investors can further improve their inflation hedge by incorporating the long
term interactions between his own inflation exposure and the foreign inflation
measures.
Focusing on the major inflation-linked security markets, I find an increase
of the inflation risk premium over the financial crisis in the UK, whereas in
the US it decreased. Since the parameter uncertainty of these estimates is
large, and increased over the financial crisis in both the UK and US markets, I
present a framework in which investors can quantify and integrate it in their
long term investment decisions.
Finally, I demonstrate that the difficulty of estimating the equity risk premium
is the largest source of parameter uncertainty in defined contribution
pension contracts. I introduce a methodology to take parameter uncertainty
into account, so that participants can set contributions that reflect the uncertainty
about their replacement rate at retirement.
Overall, this thesis demonstrates robust methods to incorporate the effects
of parameter uncertainty and contributes to the literature on how parameter
uncertainty of financial models can substantially affect the investors’ investment
risk.
Original languageEnglish
QualificationDoctor of Philosophy
Awarding Institution
  • Tilburg University
Supervisors/Advisors
  • Mahieu, Ronald, Promotor
  • Nijman, Theo, Promotor
Thesis sponsors
Award date8 Oct 2014
Place of PublicationTilburg
Publisher
Print ISBNs9789056684037
Publication statusPublished - 8 Oct 2014

Fingerprint

Parameter uncertainty
Financial markets
Model uncertainty
Inflation
Investors
Hedging
Financial crisis
Investment horizon
Uncertainty
Hedge
Securities market
Investment decision
Methodology
Retirement
Inflation risk premium
Equity risk premium
Equity risk
Replacement rate
Interaction
Financial models

Cite this

de Roode, F. A. (2014). Model uncertainty in financial markets: Long run risk and parameter uncertainty. Tilburg: CentER, Center for Economic Research.
de Roode, F.A.. / Model uncertainty in financial markets : Long run risk and parameter uncertainty. Tilburg : CentER, Center for Economic Research, 2014. 186 p.
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de Roode, FA 2014, 'Model uncertainty in financial markets: Long run risk and parameter uncertainty', Doctor of Philosophy, Tilburg University, Tilburg.

Model uncertainty in financial markets : Long run risk and parameter uncertainty. / de Roode, F.A.

Tilburg : CentER, Center for Economic Research, 2014. 186 p.

Research output: ThesisDoctoral Thesis

TY - THES

T1 - Model uncertainty in financial markets

T2 - Long run risk and parameter uncertainty

AU - de Roode, F.A.

PY - 2014/10/8

Y1 - 2014/10/8

N2 - Uncertainty surrounding key parameters of financial markets, such as the in-flation and equity risk premium, constitute a major risk for institutional investorswith long investment horizons.Hedging the investors’ inflation exposure can be challenging due to the lackof domestic inflation-linked securities. I show that inflation hedging investorscan benefit from holding bonds that are linked to inflation in foreign countries.Investors can further improve their inflation hedge by incorporating the longterm interactions between his own inflation exposure and the foreign inflationmeasures.Focusing on the major inflation-linked security markets, I find an increaseof the inflation risk premium over the financial crisis in the UK, whereas inthe US it decreased. Since the parameter uncertainty of these estimates islarge, and increased over the financial crisis in both the UK and US markets, Ipresent a framework in which investors can quantify and integrate it in theirlong term investment decisions.Finally, I demonstrate that the difficulty of estimating the equity risk premiumis the largest source of parameter uncertainty in defined contributionpension contracts. I introduce a methodology to take parameter uncertaintyinto account, so that participants can set contributions that reflect the uncertaintyabout their replacement rate at retirement.Overall, this thesis demonstrates robust methods to incorporate the effectsof parameter uncertainty and contributes to the literature on how parameteruncertainty of financial models can substantially affect the investors’ investmentrisk.

AB - Uncertainty surrounding key parameters of financial markets, such as the in-flation and equity risk premium, constitute a major risk for institutional investorswith long investment horizons.Hedging the investors’ inflation exposure can be challenging due to the lackof domestic inflation-linked securities. I show that inflation hedging investorscan benefit from holding bonds that are linked to inflation in foreign countries.Investors can further improve their inflation hedge by incorporating the longterm interactions between his own inflation exposure and the foreign inflationmeasures.Focusing on the major inflation-linked security markets, I find an increaseof the inflation risk premium over the financial crisis in the UK, whereas inthe US it decreased. Since the parameter uncertainty of these estimates islarge, and increased over the financial crisis in both the UK and US markets, Ipresent a framework in which investors can quantify and integrate it in theirlong term investment decisions.Finally, I demonstrate that the difficulty of estimating the equity risk premiumis the largest source of parameter uncertainty in defined contributionpension contracts. I introduce a methodology to take parameter uncertaintyinto account, so that participants can set contributions that reflect the uncertaintyabout their replacement rate at retirement.Overall, this thesis demonstrates robust methods to incorporate the effectsof parameter uncertainty and contributes to the literature on how parameteruncertainty of financial models can substantially affect the investors’ investmentrisk.

M3 - Doctoral Thesis

SN - 9789056684037

T3 - CentER Dissertation Series

PB - CentER, Center for Economic Research

CY - Tilburg

ER -

de Roode FA. Model uncertainty in financial markets: Long run risk and parameter uncertainty. Tilburg: CentER, Center for Economic Research, 2014. 186 p. (CentER Dissertation Series).