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

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.