Monthly Archives: December 2014

The bottom panel in Tables 3-5 reports the optimal portfolio allocation and consumption choice when the assets available to investors are three-month, three-year, and ten-year nominal bonds. Investors hold highly leveraged portfolios, with long positions in the three-year nominal bond and short positions in the ten-year nominal bond. Risk-tolerant investors do this because they are attracted by the high Sharpe ratio of the three-year nominal bond relative to the Sharpe ratio of the ten-year nominal bond, and they short ten-year bonds to reduce their portfolio risk. Conservative investors exploit the fact that three-year bonds have a greater real-interest-rate sensitivity than ten-year bonds to create bond portfolios with similar properties to long-term indexed bonds, even though indexed bonds are not directly available in the marketplace. They are not able to avoid all inflation risk, however, because there are three sources of risk in the model—shocks to real interest rates, expected inflation, and unexpected inflation—and only three assets are available. Thus markets are not quite complete. payday loans speedy cash

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Unconstrained demand

The results in the previous section can easily be generalized to the case where the investor can hold only nominal bonds, or both nominal and indexed bonds. We can assume that the short-term asset is indexed or nominal, or allow both types of shortterm asset. For realism, however, and since inflation risk is modest at the short end of the term structure, we now assume that the one-period asset is nominal.

Even in the presence of nominal assets, the log consumption-wealth ratio still depends only on the state variable xtj and not on expected inflation zt. Furthermore this ratio is still a linear function of xt, and the slope coefficient is still given by bi = p(l — ф) /(1 — рф) as in equation (28). The menu of available assets affects this coefficient only indirectly by affecting the intercept &o of the consumption function, which in turn determines the log-linearization parameter p.

We ...

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On the economic definition of the riskless asset

In financial economics a one-period indexed bond is usually thought of as riskless. Over one period, a nominal bond is a good substitute for an indexed bond (Viard 1993), and thus by extension the riskless asset is often identified with a short-term nominal asset such as a Treasury bill. In a world with time-varying interest rates, however, only the current short-term real interest rate is riskless; future short-term real interest rates are uncertain. This makes a one-period bond risky from the perspective of long-horizon investors. For such investors, a more natural definition of a riskless asset might be a real perpetuity, since this asset pays a fixed coupon of one unit of consumption per period forever.

We now show that in our model an individual who is infinitely risk-averse and infinitely reluctant to substitute consumption intertemporally chooses a portfolio of indexed bonds that is equivalent to a real perpetuity. That is, if a real perpetuity were available, the portfolio would be fully invested in that bond. To see this, we first note that, from (30) and (29), the interest-rate sensitivity of the the optimal portfolio for an infinitely risk-averse individual is given by

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