Consumption and Investment with Interest Rate Risk

26 Pages Posted: 8 Feb 2017 Last revised: 22 Jul 2018

See all articles by Paolo Guasoni

Paolo Guasoni

Boston University - Department of Mathematics and Statistics; Dublin City University - School of Mathematical Sciences; University of Bologna - Department of Statistics

Gu Wang

Worcester Polytechnic Institute

Date Written: July 11, 2018

Abstract

This paper investigates the optimal investment and consumption problem in a continuous-time financial market for investors with power utility on consumption, who face partially hedgeable interest rate risk. With no analytical solution to the optimal strategies, closed-form approximate strategies are derived by solving the same optimization problem in two fictitious complete markets. The approximate solution helps verify the existence and the optimality of the solution to the original optimization problem and provides bounds of the optimal consumption strategy and the approximation error, both in closed form. As the interest rate increases, if the investor's risk aversion is greater than one, the wealth effect dominates the substitution effect, and consumption increases. If risk aversion is less than one, then the substitution effect dominates, and the investor consumes less.

Keywords: portfolio choice, consumption, stochastic interest rate, incomplete market, power utility

JEL Classification: G11, G12

Suggested Citation

Guasoni, Paolo and Guasoni, Paolo and Wang, Gu, Consumption and Investment with Interest Rate Risk (July 11, 2018). Available at SSRN: https://ssrn.com/abstract=2912665 or http://dx.doi.org/10.2139/ssrn.2912665

Paolo Guasoni

Boston University - Department of Mathematics and Statistics ( email )

Boston, MA 02215
United States

Dublin City University - School of Mathematical Sciences ( email )

Dublin
Ireland

HOME PAGE: http://www.guasoni.com

University of Bologna - Department of Statistics ( email )

Bologna, 40126
Italy

Gu Wang (Contact Author)

Worcester Polytechnic Institute ( email )

100 Institute Road
Worcester, MA 01609
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
99
Abstract Views
954
Rank
397,440
PlumX Metrics