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

Farid Mkaouar, Jean-Luc Prigent () and Ilyes Abid

Economic Modelling, 2017, vol. 67, issue C, 228-247

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.

Keywords: Portfolio optimization; Stochastic interest rate; Inflation-indexed bonds; Incompleteness; Compensating variation (search for similar items in EconPapers)
JEL-codes: C61 G11 G12 (search for similar items in EconPapers)
Date: 2017
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DOI: 10.1016/j.econmod.2016.12.017

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