Intertemporal Investment Strategies Under Inflation Risk

Quantitative Finance Research Centre Working Paper No. 192

53 Pages Posted: 16 Mar 2008

See all articles by Carl Chiarella

Carl Chiarella

University of Technology, Sydney - UTS Business School, Finance Discipline Group

Chih-Ying Hsiao

Bielefeld University - Department of Business Administration and Economics

Willi Semmler

The New School - Department of Economics; Universitaet Bielefeld; IIASA

Date Written: January 2007

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.

Keywords: inflation-indexed bonds, intertemporal asset allocation, inflationary expectations

Suggested Citation

Chiarella, Carl and Hsiao, Chih-Ying and Semmler, Willi, Intertemporal Investment Strategies Under Inflation Risk (January 2007). Quantitative Finance Research Centre Working Paper No. 192. Available at SSRN: https://ssrn.com/abstract=1106066 or http://dx.doi.org/10.2139/ssrn.1106066

Carl Chiarella (Contact Author)

University of Technology, Sydney - UTS Business School, Finance Discipline Group ( email )

PO Box 123
Broadway, NSW 2007
Australia
+61 2 9514 7719 (Phone)
+61 2 9514 7711 (Fax)

HOME PAGE: http://www.business.uts.edu.au/finance/

Chih-Ying Hsiao

Bielefeld University - Department of Business Administration and Economics ( email )

P.O. Box 100131
D-33501 Bielefeld, NRW 33501
Germany

Willi Semmler

The New School - Department of Economics ( email )

65 Fifth Avenue
New York, NY 10003
United States

HOME PAGE: http://www.newschool.edu/nssr/faculty/?id=4e54-6b79-4e41-3d3d

Universitaet Bielefeld ( email )

Universitätsstraße 25
Bielefeld, NRW
Germany

IIASA ( email )

Schlossplatz 1
Laxenburg/Austria, A-2361
Austria

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
172
Abstract Views
1,506
rank
186,196
PlumX Metrics