Intertemporal Investment Strategies Under Inflation Risk

Abstract

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.

Optimal portfolio‐consumption choice under stochastic inflation with nominal and indexed bonds

“…Munk et al 4 estimate that the correlation is only 0.016 and an unpublished work by Chiarella et al . 12 reports the correlation as − 0.0688). Accordingly, the estimation error accounts for most of the uncertainty of π t .…”

A Diffusion Model for Long-Term Optimization in the Presence of Stochastic Interest and Inflation Rates

“…In this paper, first we introduce a general multifactor term structure precluding any arbitrage opportunity. We adopt the model introduced by Chiarella et al (2007). In this framework, both inflation-indexed bonds and nominal bonds can be priced under a risk-neutral probability.…”

“…4 As in Chiarella et al (2007), we assume that inflation-indexed bonds are available on the financial market, which can potentially reduce the inflation risk. But contrary to Chiarella et al (2007), we consider constant maturation bonds as proposed by Bajeux-Besnainou et al (2001). Indeed, such bonds allow to obtain a Bond/Stock ratio which increases with time, when there exists no inflation.…”

Optimal Investment-Consumption Strategy under Inflation in a Markovian Regime-Switching Market

“…Here, we introduce some existing literature allowing for inflation. For the optimal portfolio selection problem under inflation, Brennan and Xia [35], Munk et al [36], and Chiarella et al [37] aimed to maximize the expected power utility from terminal real wealth and obtained the closedform investment strategies for the investors. Menoncin [38] studied an optimal portfolio selection problem for a HARA utility investor under stochastic inflation and wage income.…”