Optimal consumption and investment strategies with stochastic interest rates

We characterize the solution to the consumption and investment problem of a power utility investor in a continuous-time dynamically complete market with stochastic changes in the opportunity set. Under stochastic interest rates the investor optimally hedges against changes in the term structure of i...

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Bibliographic Details
Published in:Journal of banking & finance 2004-08, Vol.28 (8), p.1987-2013
Main Authors: Munk, Claus, Sørensen, Carsten
Format: Article
Language:English
Subjects:
Banking
Bonds
Consumption
Dynamic asset allocation
Finance
Hedging
Interest rates
Investment
Investment policy
Mathematical models
Stochastic processes
Studies
Term structure of interest rates
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Summary:We characterize the solution to the consumption and investment problem of a power utility investor in a continuous-time dynamically complete market with stochastic changes in the opportunity set. Under stochastic interest rates the investor optimally hedges against changes in the term structure of interest rates by investing in a coupon bond, or portfolio of bonds, with a payment schedule that equals the forward-expected (i.e. certainty equivalent) consumption pattern. Numerical experiments with two different specifications of the term structure dynamics (the Vasicek model and a three-factor non-Markovian Heath–Jarrow–Morton model) suggest that the hedge portfolio is more sensitive to the form of the term structure than to the dynamics of interest rates.
ISSN:0378-4266
1872-6372
DOI:10.1016/j.jbankfin.2003.07.002