Inflation Risk and Inflation-Protected and Nominal Bonds
Philipp K. Illeditsch
University of Pennsylvania - Finance Department
I decompose inflation risk into (i) a component that is correlated with factors that determine investor’s preferences and investment opportunities and real returns on real assets (inflation-protected bonds, stocks, corporate bonds, real estate, commodities, derivatives), and (ii) a residual component. In equilibrium, only the first component earns a risk premium. Therefore investors should avoid exposure to the residual component. All nominal bonds, including the money-market account, are equally exposed to the residual component. Hence, every investor should put 100% of her wealth in real assets and finance every long/short position in nominal bonds with an equal amount of other nominal bonds or by borrowing/lending cash, that is, investors should hold a zero- investment portfolio of nominal bonds and cash.
Number of Pages in PDF File: 59
Keywords: Inflation Risk, Nominal Bonds, Cash, Money Market Account, Inflation-Protected Bonds, Inflation-Indexed Bonds, TIPS, Dynamic Asset Allocation, Portfolio Choice.
JEL Classification: G11
Date posted: August 25, 2007 ; Last revised: April 15, 2016
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