AbstractThis paper investigates the multivariate pricing of coupon longevity bonds (CLBs) using the Fama–French–Lee–Carter (FF–LC) five-vector model in the framework of Bayesian integrated nested Laplace approximation (INLA) in the presence of geopolitical risk (GPR). The variance-covariance and correlation matrices are utilized to capture the interdependence between factors. We prove the generalization of multivariate Bayesian INLA with the basic probability assignment which is utilized as a posterior uncertainty belief associated with the GPR uncertainty category (a rich representation of GPR uncertainty) that is an element of the frame of discernment in the CLB posterior estimation. INLA Bayesian principal component analysis (INLA-BPCA) is applied to the model prediction parameters generating a multivariate normally distributed posterior. The deviance information criterion (DIC) assesses optimal factor selection. The results show that the BPCA posterior gains a feature that allows for a balance between the goodness-of-fit and complexity in hierarchical model selection by incorporating the retained principal components (or the effective number of parameters) from the DIC formula. Furthermore, it is also evident in our results, that the DIC outperforms the Bayesian information criterion (BIC), and Watanabe–Akaike information criterion (WAIC). The DIC is more suitable for Bayesian-based parametric models with high complexity. Lastly, the INLA-BPCA-DIC is applied to select the best longevity factors that yield a low longevity price of risk for insurers and practitioners, to attenuate the risks associated with investing in CLBs in the presence of geopolitical uncertainty shocks.
Read full abstract