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Measuring the unmeasurable: an application of uncertainty quantification to Treasury bond portfolios

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  • Jingnan Chen
  • Mark D. Flood
  • Richard B. Sowers

Abstract

We extract from the yield curve a new measure of fundamental economic uncertainty, based on McDiarmid’s diameter and related methods for optimal uncertainty quantification (OUQ). OUQ seeks analytical bounds on a system’s behaviour, even where aspects of the underlying data-generating process and system response function are not completely known. We use OUQ to stress test a simple fixed-income portfolio, certifying its safety—i.e. that potential losses will be ‘small’ in an appropriate sense. The results give explicit tradeoffs between: scenario count, maximum loss, test horizon, and confidence level. Unfortunately, uncertainty peaks in late 2008, weakening certification assurances just when they are needed most.

Suggested Citation

  • Jingnan Chen & Mark D. Flood & Richard B. Sowers, 2017. "Measuring the unmeasurable: an application of uncertainty quantification to Treasury bond portfolios," Quantitative Finance, Taylor & Francis Journals, vol. 17(10), pages 1491-1507, October.
    • Handle: RePEc:taf:quantf:v:17:y:2017:i:10:p:1491-1507
    DOI: 10.1080/14697688.2017.1296176
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