An evaluation of some popular investment strategies under stochastic interest rates

The payoff distribution pricing model (PDPM) of Dybvig [13] is a powerful tool for measuring the inefficiency of any investment strategy in a multiperiod setting. In this study, we extend the PDPM in three major ways. Firstly, we develop an operational formula for computing the inefficiency amount of a strategy. Secondly, we use six different investment horizons spanning from one month to five years to cater to short-term and long-term investors. Thirdly, and most importantly, we incorporate the stochastic nature of the short interest rate into the PDPM using two well-known interest rate models. Under such formulation, we investigate the inefficiency of three popular investment strategies. Our simulation results show that their inefficiency amounts increase considerably when the investment horizon lengthens and/or when the short interest rate is stochastic. In general, the stop-loss strategy performs better than the other two strategies in terms of inefficiency amount.