Portfolio selection with inflation-linked bonds and indexation lags

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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.
Original languageEnglish
Article number103727
Pages (from-to)1-17
Number of pages17
JournalJournal of Economic Dynamics and Control
Volume107
DOIs
Publication statusPublished - Oct 2019

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Keywords

  • Indexation lags
  • Bond portfolio selection
  • Inflation-linked bond
  • Intertemporal hedging
  • Stochastic delay differential equations
  • Piecewise dynamic programming approach

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