Optimal Consumption and Portfolio Decisions with Partially Observed Real Prices

Abstract

We consider optimal consumption and portfolio investment problems of an investor who is interested in maximizing his utilities from consumption and terminal wealth subject to a random inflation in the consumption basket price over time. We consider two cases: (i) when the investor observes the basket price and (ii) when he receives only noisy observations on the basket price. We derive the optimal policies and show that a modified Mutual Fund Theorem consisting of three funds holds in both cases. The compositions of the funds in the two cases are the same, but in general the investor's allocations of his wealth into these funds will differ. However, in the particular case when the investor has CRRA utility, his optimal investment allocations into these funds are also the same in both cases.

Keywords: Optimal Consumption and Investment, Inflation, Stochastic Control with partial observations, Separation Principle, Zakai Equation

JEL Classification: C61, D83, G11,D11, D91