- Research
- Open Access
Portfolio decision with a quadratic utility and inflation risk
- Byung Hwa Lim^{1} and
- Ho-Seok Lee^{2}Email author
https://doi.org/10.1186/s13662-018-1834-1
© The Author(s) 2018
- Received: 10 July 2018
- Accepted: 2 October 2018
- Published: 11 October 2018
Abstract
This paper considers a portfolio selection problem with a quadratic utility of consumption, which is symmetric with respect to a bliss point. At bliss point, the utility function has its maximum value and further consumption lowers the utility. In the presence of inflation risk, we introduce an inflation-linked index bond to manage the inflation risk and derive explicit expressions for the optimal consumption and portfolios by applying duality method. Based on quantitative results, we see that inflation-linked index bond plays an important role in choosing consumption and portfolio rules.
Keywords
- Martingale duality method
- Portfolio selection
- Quadratic utility
- Inflation risk
- Inflation-linked index bond
1 Introduction
A quadratic utility function is widely applied in economic and finance theory. The main advantage of a quadratic utility function is its tractability, and this is the main reason why the quadratic function is applied as an objective function for various optimization problems in economics and finance. In particular, modern investment theory and practice are mainly based on the mean–variance portfolio theory developed by Markowitz [7], where the analysis is based on the quadratic function of portfolio return. The analysts in practice apply the mean–variance-efficient portfolios for asset allocation. Recently, Sharpe [9] showed that the mean–variance portfolio allocation has similar results to that of the expected utility asset allocation if we consider the quadratic utility whose risk aversion is measured by the variance of portfolio return.
In this paper we consider a quadratic utility as an agent’s preference. Similar to the traditional utility functions of constant relative risk aversion (CRRA) or constant absolute risk aversion (CARA), the law of diminishing marginal utility still holds for the quadratic utility. The marginal utility, however, can be negative when the consumption level is higher than a bliss point. In other words, above a bliss point, if the agent consumes more he/she reduces utility. Thus, the optimal level of consumption and value function should be constant if the wealth level is greater than the critical level at which the optimal consumption rate is the bliss point. With a quadratic utility function, investment pattern is quite different from that when using other utility functions for a sufficiently high wealth level. For example, for an agent with a quadratic utility investment in the risky asset is zero when the wealth level is larger than the bliss level (see, e.g., Koo et al. [5] or Rho et al. [8]).
Due to the negative marginal utility for higher consumption levels, the quadratic utility seems to be unrealistic. It is worth to note, however, that the quadratic utility is sufficient to explain the agent’s economic behavior for the realistic level of wealth. Koo et al. [5] studied the quadratic utility in the presence of subsistence consumption constraint, and Rho et al. [8] investigated the effect of borrowing limits on the consumption and investment of the agent with a quadratic utility.
If the time horizon is long enough, it is persuasive to incorporate the inflation risk into consumption and portfolio selection problem. In our continuous-time model, the time horizon is infinite, and thus we expect that the inflation rate would significantly affect the long-term financial planning. To hedge the inflation risk, we introduce the inflation-linked index bond. In fact, many developed countries already have inflation-linked securities which are traded in the financial market. Especially, Treasury Inflation-Protected Securities (TIPS) which were introduced in 1997 have become the most traded bonds in the US bond market.
In this paper, we provide explicit expressions for consumption and portfolio rules by applying the duality approach. Due to the optimal consumption process, we have to separate the wealth into three regions as in Koo et al. [5] and Rho et al. [8]. In the third region, where the wealth level is above the bliss level, the optimal consumption stays constant as its maximum so the value function is also fixed. To make the value function constant, there should be no risky asset investment. This fact is well-described in Koo et al. [5] and Rho et al. [8]. In the presence of inflation risk, however, even though the value function in the third region is still constant, the optimal investment in an inflation-linked index bond is not fixed. To hedge the inflation risk, all the financial wealth is invested in an inflation-linked index bond and investment in other assets becomes zero in the third region. When the wealth level is below the bliss level, the role of inflation-linked index bond can be different according to market parameters. In particular, for sufficiently large growth rate of the price process, the demand for speculative motive is reflected only on the inflation-linked index bond. For a small growth rate of the price process, however, the demand for speculative motive is distributed into both portfolios of inflation-linked index bond and the risky asset.
There are large strands of literature on the portfolio selection problem with inflation risk, and most studies consider the inflation-linked index bond to manage inflation risk. Fischer [3] investigated the demand for index bond and claimed its introduction. Later, Campbell and Viceira [2] and Brennan and Xia [1] studied the dynamic asset allocation in the presence of inflation and interest risks. Gong and Li [4] incorporated the subsistence consumption constraint into the model with inflation risk. Recently, Kwak and Lim [6] investigated the effect of inflation risk on life-insurance purchase and provided quantitative analysis of the role of an index bond.
This paper is organized as follows. In Sect. 2, we provide the financial market in the presence of inflation risk. We introduce an inflation-linked index bond to hedge the inflation risk. In Sect. 3, we state the optimization problem with a quadratic utility function and seek to derive explicit solutions to the optimization problem by applying the duality approach. In Sect. 4, explicit forms of the optimal consumption and portfolios are given, and we provide some implications of the results in Sect. 5. Finally, Sect. 6 concludes.
2 Model
Lemma 1
Proof
3 Optimization problem
Definition 1
- (a)
\(X_{t}\) evolves according to (2.1), \(X_{0}=x\), and \({X_{t}>-\frac{y}{r}}\), \(t \geq 0\),
- (b)
c is a measurable, adapted nonnegative process, and \(\int_{0}^{t} c_{s}\,ds<\infty \), for all \(t\geq 0\) a.s.,
- (c)
π is a measurable, adapted process and \(\int_{0}^{t} ( \pi^{2}_{0,s}+\pi^{2}_{1,s} )\,ds<\infty\) for all \(t\geq 0\) a.s.
Denote by \(\mathcal{A}(x)\) the set of all admissible policies at x. Then our optimization problem is stated as follows.
Problem 1
Proposition 1
We assume that the following inequality holds.
Assumption 1
Under this assumption, we can show that the constants \(D_{1}\) and \(D_{2}\) are positive.
Lemma 2
Proof
4 Solution
Theorem 1
Proof
It is worth to note that the first region, \(-y/r< x<\tilde{x}\), corresponds to \(\lambda >1\) and in that region the optimal consumption rate is zero. Thus, the agent endures zero consumption until when the wealth level is greater than x̃. The optimal consumption rate is asymmetric with respect to the bliss point even though the utility function is symmetric. We summarize the optimal consumption and portfolios in the next theorem.
Theorem 2
- (1)For \(-\frac{y}{r}< X_{t}<\widetilde{x}\),where \(\lambda_{t}^{**}\) solves \(X_{t}=h_{2}(\lambda_{t}^{**})\).$$ \textstyle\begin{cases} {X_{t}=-n_{-} D_{2} (\lambda_{t}^{**})^{n_{-}-1}-\frac{y}{r} } , \\ {c_{t}^{*}=0}, \\ {\pi_{0,t}^{*} X_{t}= \{ -\frac{\theta_{1}}{\sigma_{S}}+ ( \frac{ \rho }{\sigma_{S}}-\frac{1}{\sigma_{P}} ) \frac{\theta_{2}}{\sqrt{1- \rho^{(2}}} \} n_{-}(n_{-}-1)D_{2}(\lambda_{t}^{**})^{n_{-}-1} }, \\ {\pi_{1,t}^{*} X_{t}= ( \frac{\theta_{1}}{\sigma_{S}}-\frac{\rho \theta_{2}}{\sigma_{S}\sqrt{1-\rho^{2}}} ) n_{-}(n_{-}-1)D_{2}( \lambda_{t}^{**})^{n_{-}-1}}, \\ \pi_{2,t}^{*} X_{t}=X_{t}-\pi_{0,t}^{*} X_{t}-\pi_{1,t}^{*} X_{t}, \end{cases} $$
- (2)For \(\widetilde{x}\leq X_{t}<\bar{x}\),where \(\lambda_{t}^{*}\) solves \(X_{t}=h_{1}(\lambda_{t}^{*})\).$$ \textstyle\begin{cases} {X_{t}=-n_{+}D_{1}(\lambda_{t}^{*})^{n_{+}-1}+\frac{1}{2Q ( \theta _{1}^{2}+\theta_{2}^{2}+\beta -2r ) }\lambda_{t}^{*}-\frac{y}{r}+ \frac{1}{2Qr}} , \\ {c_{t}^{*}=\frac{1-\lambda_{t}^{*}}{2Q}}, \\ {\pi_{0,t}^{*} X_{t}= \{ -\frac{\theta_{1}}{\sigma_{S}}+ ( \frac{ \rho }{\sigma_{S}}-\frac{1}{\sigma_{P}} ) \frac{\theta_{2}}{\sqrt{1- \rho^{2}}} \} \{ n_{+}(n_{+}-1)D_{1}(\lambda_{t}^{*})^{n _{+}-1}- \frac{1}{2Q ( \theta_{1}^{2}+\theta_{2}^{2}+\beta -2r ) } \lambda_{t}^{*} \} }, \\ {\pi_{1,t}^{*} X_{t}= ( \frac{\theta_{1}}{\sigma_{S}}-\frac{\rho \theta_{2}}{\sigma_{S}\sqrt{1-\rho^{2}}} ) \{ n_{+}(n_{+}-1)D _{1}(\lambda_{t}^{*})^{n_{+}-1}-\frac{1}{2Q ( \theta_{1}^{2}+\theta _{2}^{2}+\beta -2r ) }\lambda_{t}^{*} \} }, \\ \pi_{2,t}^{*} X_{t}=X_{t}-\pi_{0,t}^{*} X_{t}-\pi_{1,t}^{*} X_{t}, \end{cases} $$
- (3)For \(X_{t}\geq \bar{x}\),$$ \textstyle\begin{cases} {c_{t}^{*}=\frac{1}{2Q}}, \\ {\pi_{0,t}^{*} X_{t}=0}, \\ {\pi_{1,t}^{*} X_{t}=0}, \\ \pi_{2,t}^{*} X_{t}=X_{t}. \end{cases} $$
Proof
Lastly, the case for \(X_{t}\geq \bar{x}\) can be derived by letting \(\lambda_{t}^{*}\rightarrow 0\) in the case where \(\widetilde{x}\leq X_{t}<\bar{x}\). □
5 Discussion
In this section, we discuss the quantitative results obtained from the optimization problem and exhibit implications through some numerical illustrations. Let us rewrite the optimal policies as follows.
Remark 1
Let us call \((-y/r, \tilde{x}), [\tilde{x}, \bar{x})\), and \([\bar{x}, \infty )\) as regions 1, 2, and 3, respectively. In region 3, as we expected, the optimal consumption rate is \(1/2Q\) at which the quadratic utility function has its maximum. Interestingly, we also have a constant consumption in region 1. The main reason why the agent consumes nothing in region 1 might be that the agent wants to get out of the lower wealth level as soon as possible. This effort could be compensated as additional consumption in region 2.
Similar to the consumption rate, the portfolios can also be described according to the different regions. We consider for the case where \(\theta_{1}-\rho \theta_{2}/\sqrt{1-\rho^{2}}>0\). Then, the investment in the risky asset, \(\pi_{1,t}X_{t}\), is always non-negative, and the investment in the riskless asset (or bank account), \(\pi_{0,1}X_{t}\), is always non-positive. Note that \(y/r\) is the present value of the future income stream, called human capital. We also call the sum of financial wealth \(X_{t}\) and human capital as the total capital, which is always non-negative.
Now we can describe the optimal portfolios in more details. In region 1, the investment in the inflation-linked index bond consists of two components, which are the demand for hedging inflation risk and an additional investment which is proportion to the total capital. Since \(n_{-}<0\), the additional investment is positive if \(\theta_{2}>0\), which implies the speculative or myopic demand due to the excess return on the inflation-linked index bond. Moreover, under the condition that \(\theta_{1}-\rho \theta_{2}/\sqrt{1-\rho^{2}}>0\), the investment in risky asset also represents myopic demand which is proportion to the total capital. We can verify that the total myopic demand in the risky asset and inflation-linked index bond is borrowed from the bank account.
Similar to the portfolios in region 1, in region 2 the total wealth is invested in the inflation-linked index bond to hedge the inflation risk and there exists an additional investment in that bond. The myopic demand, however, is not proportional to the total capital anymore. We see that the second term in (5.4) represents the myopic demand and it is proportional to the difference between x̄ and current wealth. Note that x̄ is the wealth level at bliss point. Thus, in region 2, x̄ plays a role of target wealth and a proportion \((\bar{x}-X_{t})\) is invested as myopic demand. We can also confirm that the optimal investment in the risky asset given in (5.3) consists of two components, and the first one, which is a myopic demand, is proportional to \((\bar{x}-X_{t})\).
Under Assumption 1, we have \(n_{+}<2\). Thus, the second term of (5.3) in region 2 is positive. Since the coefficient \(D_{1}\) is determined by the boundary condition at x̃, we can describe the second term as the hedging demand for not falling into region 1. Again, we can verify that, except for the inflation risk hedging demand, the total investment in the risky asset and the inflation-linked index bond is borrowed from the bank account as we can see in the portfolio \(\pi_{0,t}X_{t}\) in (5.2).
In region 3, the investment in the risky asset and bank account becomes zero and all the financial wealth is invested in the inflation-linked index bond. This is a quite different result from the case with other types of utility function such as CRRA or CARA. Since the quadratic utility has a bliss point and the value function is flat for wealth levels that are larger than bliss level of wealth, there should be no speculative motive, and thus, there is no myopic demand in asset allocation. In particular, we have the myopic demand in both the risky asset and the inflation-linked index bond as explained before. They converge to zero in region 3. Moreover, the hedging demand for not falling into the region 1, which is the last term of the portfolio (5.3) in region 2, also converges to zero in region 3. This is because the financial wealth is large enough. Recall that in region 2, except for the inflation risk hedging demand, all the myopic and hedging demand is borrowed from the bank account. Thus, the investment in the bank account, \(\pi_{0,t}X_{t}\), should be also zero and, as a result, an inflation-risk hedging demand exists only in region 3. To sum up, in the presence of inflation risk and the inflation-linked index bond, there exists no demand in the risky asset or in the bank account. Instead, only inflation risk hedging demand remains. Neither myopic demand nor other hedging demand is necessary.
6 Conclusions
In this paper, we study the optimal consumption and portfolio decision with a quadratic utility in the presence of inflation risk. For a hedging instrument for inflation risk, we introduce an inflation-linked index bond which is directly linked to the price process. Depending on market parameters, the investment in the risk asset and in the inflation-linked index bond exhibit quite different patterns. For the life-time financial planning, the inflation risk is easily ignored but it may frustrate an agent which consumes and invests optimally. Therefore, it is worthwhile to look into how an agent manages the inflation risk in the presence of an inflation-linked index bond through lifetime utility maximization with a quadratic utility function.
Declarations
Acknowledgements
We are grateful to Yong Hyun Shin for helpful comments and suggestions.
Funding
Lim was supported by the National Research Foundation of Korea Grant funded by the Korean Government (NRF-2014S1A5A8018920, NRF-2017R1E1A1A03071107). Lee was supported by the National Research Foundation of Korea Grant funded by the Korean Government (NRF-2016R1D1A1B03933406) and by the Research Grant of Kwangwoon University in 2018.
Authors’ contributions
All authors contributed equally to the writing of this paper. All authors read and approved the final manuscript.
Competing interests
The authors declare that they have no competing interests.
Open Access This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license, and indicate if changes were made.
Authors’ Affiliations
References
- Brennan, M.J., Xia, Y.: Dynamic asset allocation under inflation. J. Finance 57, 1201–1238 (2002) View ArticleGoogle Scholar
- Campbell, J.Y., Viceira, L.M.: Who should buy long-term bonds? Am. Econ. Rev. 91, 99–127 (2001). https://doi.org/10.1257/aer.91.1.99 View ArticleGoogle Scholar
- Fischer, S.: The demand for index bonds. J. Polit. Econ. 83, 509–534 (1975) View ArticleGoogle Scholar
- Gong, N., Li, T.: Role of index bonds in an optimal dynamic asset allocation model with real subsistence consumption. Appl. Math. Comput. 174, 710–731 (2006) MathSciNetMATHGoogle Scholar
- Koo, J.L., Ahn, S.R., Koo, B.L., Koo, H.K., Shin, Y.H.: Optimal consumption and portfolio selection with quadratic utility and a subsistence consumption constraint. Stoch. Anal. Appl. 34, 165–177 (2016). https://doi.org/10.1080/07362994.2015.1112748 MathSciNetView ArticleMATHGoogle Scholar
- Kwak, M., Lim, B.H.: Optimal portfolio selection with life insurance under inflation risk. J. Bank. Finance 46, 59–71 (2014) View ArticleGoogle Scholar
- Markowitz, H.M.: Portfolio selection. J. Finance 7, 77–91 (1952). https://doi.org/10.1111/j.1540-6261.1952.tb01525.x View ArticleGoogle Scholar
- Rho, K., Kim, J.Y., Shin, Y.H.: An optimal consumption and investment problem with quadratic utility and negative wealth constraints. J. Inequal. Appl. 2017(1), Article ID 188 (2017). https://doi.org/10.1186/s13660-017-1469-x MathSciNetView ArticleMATHGoogle Scholar
- Sharpe, W.F.: Expected utility asset allocation. Financ. Anal. J. 63, 18–30 (2007) View ArticleGoogle Scholar