Inflation Risk and Capital Market Equilibrium
AbstractThis paper investigates the effect of inflation uncertainty on the portfolio behavior of households and the equilibrium structure of capitol market rates. The principal findings regarding portfolio behavior are: (1.) In the presence of inflation uncertainty, households will have an inflation-hedging demand for assets other than riskless nominal bonds, which will be directly proportional to the covariance between the rate of inflation and the nominal rates of return on these other assets. (2.) An asset is a perfect inflation hedge if and only if its nominal return is perfectly correlated with the rate of inflation. The principal findings regarding capital market rates are: (1.) The equilibrium real yield spread between any risky security and riskless nominal bonds is directly proportional to the difference between the covariance of the security's nominal rate of return with the market portfolio and its covariance with the rate of inflation. (2.) As long as the net supply of monetary assets in the economy is greater than zero, an increase in inflation uncertainty will lower the risk premia on all real assets. (3.) A preliminary empirical test of the theory using rates of return on common stocks, long-term bonds, real estate and commodity futures contracts yields mixed results. The risk premia on long-term bonds and futures have the "wrong" signs.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0373.
Date of creation: Jul 1979
Date of revision:
Publication status: published as Bodie, Zvi. "Inflation Risk and Capital Market Equilibrium," Financial Review, Vol. 17, No. 1 (May 1982), pp. 1-25.
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- Bodie, Zvi, 1976. "Common Stocks as a Hedge against Inflation," Journal of Finance, American Finance Association, vol. 31(2), pages 459-70, May.
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- Solnik, Bruno H., 1978. "Inflation and Optimal Portfolio Choices," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 13(05), pages 903-925, December.
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- Martin Feldstein, 1983.
"Should Private Pensions Be Indexed?,"
in: Financial Aspects of the United States Pension System, pages 211-230
National Bureau of Economic Research, Inc.
- Zvi Bodie & Alex Kane & Robert McDonald, 1985.
"Inflation and the Role of Bonds in Investor Portfolios,"
in: Corporate Capital Structures in the United States, pages 167-196
National Bureau of Economic Research, Inc.
- Zvi Bodie & Alex Kane & Robert L. McDonald, 1985. "Inflation and the Role of Bonds in Investor Portfolios," NBER Working Papers 1091, National Bureau of Economic Research, Inc.
- Zvi Bodie, 1980. "Purchasing-Power Annuities: Financial Innovation for Stable Real Retirement Income in an Inflationary Environment," NBER Working Papers 0442, National Bureau of Economic Research, Inc.
- J. Benson Durham, 2006. "An estimate of the inflation risk premium using a three-factor affine term structure model," Finance and Economics Discussion Series 2006-42, Board of Governors of the Federal Reserve System (U.S.).
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