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.
|Date of creation:||01 Jan 2007|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: +61 2 9514 7777
Fax: +61 2 9514 7711
Web page: http://www.qfrc.uts.edu.au/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Wachter, Jessica A., 2003. "Risk aversion and allocation to long-term bonds," Journal of Economic Theory, Elsevier, vol. 112(2), pages 325-333, October.
- 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.
- Viceira, Luis & Campbell, John, 2001. "Who Should Buy Long-Term Bonds?," Scholarly Articles 3128709, Harvard University Department of Economics.
- John Y. Campbell & Luis M. Viceira, 1998. "Who Should Buy Long-Term Bonds?," NBER Working Papers 6801, National Bureau of Economic Research, Inc.
- John Y. Campbell & Luis M. Viceira, 2000. "Who Should Buy Long-Term Bonds?," Harvard Institute of Economic Research Working Papers 1895, Harvard - Institute of Economic Research.
- John Y. CAMPBELL & Luis VICEIRA, 1998. "Who Should Buy Long-Term Bonds?," FAME Research Paper Series rp5, International Center for Financial Asset Management and Engineering.
- Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
- R. C. Merton, 1970.
"Optimum Consumption and Portfolio Rules in a Continuous-time Model,"
58, Massachusetts Institute of Technology (MIT), Department of Economics.
- Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
- 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.
- Michael J. Brennan & Yihong Xia, 2002. "Dynamic Asset Allocation under Inflation," Journal of Finance, American Finance Association, vol. 57(3), pages 1201-1238, 06.
- 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.
- Kim, Tong Suk & Omberg, Edward, 1996. "Dynamic Nonmyopic Portfolio Behavior," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 141-61.
- 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.
- L. Randall Wray & Stephanie Bell, 2004. "Introduction," Chapters, in: Credit and State Theories of Money, chapter 1 Edward Elgar.
- 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.
- 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.
- 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.
- 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.
When requesting a correction, please mention this item's handle: RePEc:uts:rpaper:192. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Duncan Ford)
If references are entirely missing, you can add them using this form.