Dynamic Bond Portfolio Choice With Macroeconomic Information

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Executive Summary

This paper examines the optimal portfolio choice of a long-term bond investor, who faces a set of macroeconomic risk factors, both observable (inflation and output gap) and latent ones (real interest rate, inflation central tendency and real interest rate central tendency). It makes use of the essentially affine macro-finance term structure model of Dewachter, Lyrio and Maes (2006) that allows for time-varying risk premia, capturing the failure of the expectations hypothesis. Employing this setup, the investments as well as the hedging opportunities provided by consistently priced zero-coupon bonds for a power utility agent are examined.

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