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Long-term investment with stochastic interest and inflation rates: The need for inflation-indexed bonds

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  • Mkaouar, Farid
  • Prigent, Jean-Luc
  • Abid, Ilyes

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.

Suggested Citation

  • Mkaouar, Farid & Prigent, Jean-Luc & Abid, Ilyes, 2017. "Long-term investment with stochastic interest and inflation rates: The need for inflation-indexed bonds," Economic Modelling, Elsevier, vol. 67(C), pages 228-247.
    • Handle: RePEc:eee:ecmode:v:67:y:2017:i:c:p:228-247
    DOI: 10.1016/j.econmod.2016.12.017
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    More about this item

    Keywords

    Portfolio optimization; Stochastic interest rate; Inflation-indexed bonds; Incompleteness; Compensating variation;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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