Portfolio Selection with Inflation-linked Bonds and Indexation Lags

Abstract

We derive the price of inflation-indexed bonds of which the payments are linked to a lagged price index, and solve for the optimal bond portfolio under both inflation and indexation lags in closed form. We show that indexation lags increase the number of state variables characterizing both the bond prices and the optimal portfolio. The lag-induced state variables affect the future investment opportunity and hence further arm investors with the tools for hedging inflation risk that is, however, unhedgeable if there is no indexation lag. We find that the optimal portfolio accounts for the indexation lags by also exploring the historical information and increases investors' welfare. Therefore, we document a positive effect of the indexation lags that are typically considered as a type of market friction.

Keywords: Indexation lags, bond portfolio selection, inflation-linked bond, intertemporal hedging, %state variables, stochastic delay differential equations, piecewise dynamic programming approach

JEL Classification: C32, G11, G12