Optimal portfolio of defined contribution pension plan with climate risk under model uncertainty

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Abstract

This manuscript researches the optimal portfolio of the defined contribution (DC) pension plan, comprising a stock index and cash within a dynamic model that incorporates uncertainty regarding climate change. The global temperature is supposed to have an impact on the stock index price, with the probability distribution of the global temperature considered uncertain. To address this uncertainty, we apply Girsanov’s theorem for measure transformation. The optimal investment strategy under climate uncertainty and stochastic interest rates is derived in closed form. We further demonstrate that climate uncertainty can result in specific losses in returns. We discover through numerical analysis that the investment in the stock index is especially sensitive to climate uncertainty.

Keywords

optimal portfolio / climate uncertainty / stochastic interest rate / Girsanov’s theorem / global temperature

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