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

Jingnan Chen, Mark Flood and Richard B. Sowers

Quantitative Finance, 2017, vol. 17, issue 10, 1491-1507

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.

Date: 2017
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DOI: 10.1080/14697688.2017.1296176

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