Dynamic Asset Allocation and Fixed Income Management

TLDR

In a complete market with a Vasicek term structure, an investor with power utility can allocate between stocks and bonds. The paper seeks to solve the intertemporal investment problem for such an investor. The authors reformulate the problem as a sequence of mean‑variance optimizations over the drift and volatility of the wealth forward price and apply a quasi‑dynamic programming approach. They find that the zero‑coupon bond maturing at the investment horizon is the optimal hedge against changes in the opportunity set.

Abstract

This paper provides the solution to an intertemporal investment problem. The investor has power utility and can invest in stocks and bonds in a complete market setting where the Vasicek term structure model applies. The paper demonstrates that the zero-coupon bond with maturity at the investment horizon is the appropriate instrument for hedging changes in the opportunity set. Implementation issues are discussed and it is shown how the intertemporal investment problem can be recast as a series of mean-variance problems in terms of drift and volatility of the wealth forward price. An application based on a quasi-dynamic programming approach is considered.