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Intertemporal Investment Strategies under Inflation Risk

This paper studies intertemporal investment strategies under inflation risk by extending the intertemporal framework of Merton (1973) to include a stochastic price index. The stochastic price index gives rise to a two-tier evaluation system: agents maximize their utility of consumption in real terms while investment activities and wealth evolution are evaluated in nominal terms. We include inflation-indexed bonds in the agents’ investment opportunity set and study their effectiveness in hedging against inflation risk. A new multifactor term structure model is developed to price both inflation-indexed bonds and nominal bonds, and the optimal rules for intertemporal portfolio allocation, both with and without inflation-indexed bonds are obtained in closed form. The theoretical model is estimated using data of US bond yield, both real and nominal, and S&P 500 index. The estimation results are employed to construct the optimal investment strategy for an actual real market situation. Wachter (2003) pointed out that without inflation risk, the most risk averse agents (with an infinite risk aversion parameter) will invest all their wealth in the long term nominal bond maturing at the end of the investment horizon. We extend this result to the case with inflation risk and conclude that the most risk averse agents will now invest all their wealth in the inflation-indexed bond maturing at the end of the investment horizon.

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File URL: http://www.business.uts.edu.au/qfrc/research/research_papers/rp192.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 192.

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Length: 53
Date of creation: 01 Jan 2007
Date of revision:
Handle: RePEc:uts:rpaper:192
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Web page: http://www.qfrc.uts.edu.au/

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  1. Wachter, Jessica A., 2003. "Risk aversion and allocation to long-term bonds," Journal of Economic Theory, Elsevier, vol. 112(2), pages 325-333, October.
  2. LuisM. Viceira & John Y. Campbell, 2001. "Who Should Buy Long-Term Bonds?," American Economic Review, American Economic Association, vol. 91(1), pages 99-127, March.
  3. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  4. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
  5. Brennan, Michael J. & Schwartz, Eduardo S. & Lagnado, Ronald, 1997. "Strategic asset allocation," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1377-1403, June.
  6. Michael J. Brennan & Yihong Xia, 2002. "Dynamic Asset Allocation under Inflation," Journal of Finance, American Finance Association, vol. 57(3), pages 1201-1238, 06.
  7. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
  8. Kim, Tong Suk & Omberg, Edward, 1996. "Dynamic Nonmyopic Portfolio Behavior," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 141-61.
  9. Amin, Kaushik I. & Jarrow, Robert A., 1991. "Pricing foreign currency options under stochastic interest rates," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 310-329, September.
  10. L. Randall Wray & Stephanie Bell, 2004. "Introduction," Chapters, in: Credit and State Theories of Money, chapter 1 Edward Elgar.
  11. Jarrow, Robert & Yildirim, Yildiray, 2003. "Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM Model," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 38(02), pages 337-358, June.
  12. Wachter, Jessica A., 2002. "Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 63-91, March.
  13. Richard, Scott F., 1978. "An arbitrage model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 6(1), pages 33-57, March.
  14. Munk, Claus & Sorensen, Carsten & Nygaard Vinther, Tina, 2004. "Dynamic asset allocation under mean-reverting returns, stochastic interest rates, and inflation uncertainty: Are popular recommendations consistent with rational behavior?," International Review of Economics & Finance, Elsevier, vol. 13(2), pages 141-166.
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