Long-term investment with stochastic interest and inflation rates: The need for inflation-indexed bonds |
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Institution: | 1. Université Côte d''Azur, SKEMA, France;2. Université Côte d''Azur, CNRS, GREDEG, France;3. Université Côte d''Azur, CNRS, GREDEG, SKEMA, OFCE-DRIC, France |
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Abstract: | We examine the long term investment problem, under stochastic interest and inflation rates and within financial market incompleteness. Four basic financial assets are available on the financial market: a money market account (the cash), a real consumption good, a financial stock index and a bond with constant maturity. In this incomplete framework, we provide the general solution of the expected utility maximization. We compute the monetary loss from not having access to an inflation-indexed bond, in order to be hedged against the inflation risk. We show that this latter one usually reaches high levels (more than 1% per year). Thus, the magnitude of such costs reaches those of management fees or transaction costs. They highlight the significant value of introducing inflation-indexed bonds in the financial markets. |
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Keywords: | Portfolio optimization Stochastic interest rate Inflation-indexed bonds Incompleteness Compensating variation |
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