Embracing carbon uncertainty in portfolio construction

Dora Xia and Omar Zulaica

No 1362, BIS Working Papers from Bank for International Settlements

Abstract: We propose a framework for constructing fixed-income portfolios of sovereign bonds that integrates financial and environmental considerations. Central to our approach is the introduction of carbon returns, a concept analogous to financial returns, modeled as random variables to capture the inherent uncertainty of future carbon emissions. Based on the financial and carbon return profiles of individual countries' sovereign bonds, we employ an algorithm inspired by Hierarchical Risk Parity (HRP) to construct portfolios that balance each country's contribution to the portfolio's tail risk, as measured by expected shortfall, of financial and carbon returns. Focusing on developed market sovereign bonds, our results demonstrate that it is possible to design portfolios that effectively align decarbonization objectives with financial performance, both in-sample and out-of-sample, while accommodating diverse investor preferences.

Keywords: carbon footprints; sovereign debt; portfolio optimization; risk parity (search for similar items in EconPapers)
JEL-codes: G11 G28 Q54 Q56 (search for similar items in EconPapers)
Date: 2026-06
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.bis.org/publ/work1362.pdf Full PDF document (application/pdf)
https://www.bis.org/publ/work1362.htm (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bis:biswps:1362

Access Statistics for this paper

More papers in BIS Working Papers from Bank for International Settlements Contact information at EDIRC.
Bibliographic data for series maintained by Martin Fessler ().