The Benefits of IIBs in Long Term Investment Decisions

An EDHEC-Risk Institute Publication
The Benefits of Sovereign, Municipal and Corporate Inflation-Linked Bonds in Long-Term Investment Decisions
April 2013
with the support of
Institute
This research has benefitted from the support of Rothschild, in the context of The Case for Inflation-Linked Bonds: Issuers and Investors Perspectives research chair. We would like to thank Nol Amenc and Jean-Louis Laurens for very useful comments. Printed in France, April 2013. Copyright EDHEC 2013 The opinions expressed in this study are those of the author and do not necessarily reflect those of EDHEC Business School. The authors can be contacted at research@edhec-risk.com.
The Benefits of Sovereign, Municipal and Corporate Inflation-Linked Bonds in Long-Term Investment Decisions April 2013
Table of Contents
Executive Summary.................................................................................................. 5 1. Introduction........................................................................................................13 2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM..........................................................................................................19 3. A Formal Analysis of the Benefits of Corporate Inflation-Linked Bonds in ALM..........................................................................................................27 4. Empirical Results................................................................................................33 5. Conclusion...........................................................................................................45 Appendices...............................................................................................................49 References................................................................................................................73 About Rothschild & Cie.........................................................................................77 About EDHEC-Risk Institute.................................................................................79 EDHEC-Risk Institute Publications and Position Papers (2010-2013).........83
About the Authors

Romain Deguest is a senior research engineer at EDHEC-Risk Institute. His research on portfolio selection problems and continuous-time assetpricing models has been published in leading academic journals and presented at numerous seminars and conferences in Europe and North America. He holds masters degrees in Engineering (ENSTA) and Financial Mathematics (Paris VI University), as well as a PhD in Operations Research from Columbia University and Ecole Polytechnique. Lionel Martellini is professor of finance at EDHEC Business School and scientific director of EDHEC-Risk Institute. He has graduate degrees in economics, statistics, and mathematics, as well as a PhD in finance from the University of California at Berkeley. Lionel is a member of the editorial board of the Journal of Portfolio Management and the Journal of Alternative Investments. An expert in quantitative asset management and derivatives valuation, his work has been widely published in academic and practitioner journals and has co-authored textbooks on alternative investment strategies and fixed-income securities. Vincent Milhau is deputy scientific director of EDHEC-Risk Institute. He holds master's degrees in statistics (ENSAE) and financial mathematics (Universit Paris VII), as well as a PhD in finance (Universit de Nice-Sophia Antipolis). His research focus is on portfolio selection problems and continuous-time asset-pricing models.
Executive Summary
Executive Summary
Introduction: The Costs and Benefits of Inflation Hedging

In the presence of increased uncertainty about future price levels in developed economies, inflation hedging has become a concern of critical importance for most investors, including pension funds, which have pension payments that are often indexed with respect to consumer price or wage level indexes, but also for private investors, who consider inflation as a direct threat with respect to the protection of their purchasing power. From an investment solution perspective, the implementation of inflation-hedging portfolios seems to have become relatively straightforward given that inflationlinked (IL) bonds issued by various sovereign states can be used to achieve effective inflation hedging. In practice, however, Treasury inflation protected securities suffer from a number of severe drawbacks. First, the market capacity for these inflation-linked bonds is often limited and some large investors are unable to allocate to this asset class as much as would be optimal. A second, related, drawback is that Treasury inflation protected securities (TIPS) offer inflation protection at a prohibitive cost. Due to increasing demand from institutional investors, market prices for TIPS have soared in most countries, and real yields have dramatically declined. In a recent paper, Campbell, Schiller, and Viceira (2009) report that while during the 1990s, 10-year inflation-indexed yields averaged about 3.5% in the UK and even exceeded 4% in the US around the turn of the millennium, they both averaged below 2% in the mid-2000s and fell at a level around 1% in early 2008. This massive decline in long-term real interest rates from the
6
1990s to the 2000s implies that only the wealthiest and best funded pension plans can offer to invest substantial portions of their portfolios to such assets. Finally, and perhaps most importantly looking forward, the increasing concern over sovereign risk has led investors to question the role of sovereign bonds in their portfolio, regardless of whether or not they offer inflation protection. In this context, long-term investors are increasingly turning to other investment vehicles for inflation-hedging purposes. No readily available and extremely effective solution has however been found so far to meet the inflation hedging challenge. On the one hand, dedicated OTC derivatives such as inflation swaps can be used to customize inflation exposure for a long-term investor with inflationlinked liabilities. Such derivatives-based solutions suffer, however, from the presence of counterparty risk, an obvious preoccupation for long horizons. Besides, derivatives-based solutions can hardly be implemented for products intended for the retail or private wealth market. On the other hand, a variety of cash instruments, based on financial asset classes (stocks or roll-over of short-term bonds) or real asset classes (commodities, real estate, infrastructure, etc.), have been analyzed in terms of their ability to provide attractive inflation-hedging benefits. The results of such empirical investigations have been mixed: in most cases, except perhaps for some segments of the commodity markets, inflation protection seems to be very modest for short horizons, and remains relatively small, even if more attractive, at long horizon. Besides, all these statistical results are subject to
Executive Summary
substantial estimation risk and parameter uncertainty.1
coincides with the liability horizon, interest rate risk gradually vanishes away to leave inflation risk as the sole source of uncertainty in the liability payment. For the shortest investment horizon we consider (one month), we find that nominal bonds have good liabilityhedging properties at short horizons, with a correlation equal to 0.8 with respect to liabilities with a one-year duration, and a value extremely close to 1 for liabilities with a duration exceeding 10 years. However, when the investment horizon increases, their correlation with liabilities decreases, both in absolute and in algebraic value, and eventually becomes zero or even negative when the investment horizon is taken to coincide with the duration of the liabilities. Conversely, inflationlinked bonds exhibit low, and even slightly negative short-term correlation with changes in inflation, but they have a perfect correlation with liabilities at all horizons. In this context, it turns out that for reasonable parameter values, interest rate risk dominates inflation risk so substantially that introducing assets (e.g., commodities) with attractive inflationhedging properties but poor interest rate hedging capacities will decrease, as opposed to increase, investors welfare. Emphasizing the difference between liability-hedging and inflation hedging, we finally find that inflation-linked bonds are the only assets that allow for attractive liability hedging properties at all horizons, and as such we expect them to add substantial value in investors liability-hedging portfolios.2 Overall, it thus appears that a trade-off exists between using inflation-linked
Inflation Hedging versus Liability Hedging

Regardless of whether various asset classes may turn out to be effective or not at hedging inflation risk, it also has to be recognized that investing in asset classes other than fixed-income instruments is in any case extremely risky in the context of liability-hedging portfolios. In other words, it is important to emphasize the key difference between inflation hedging and liability hedging. While the two concepts coincide at liability maturity, they are very different in general. Shortterm (instantaneous) liability risk is driven by two main risk factors, namely inflation risk and interest rate risk. From a mathematical point, interest rate risk affects instantaneous liability risk through the impact on the discount factor, an impact that increases linearly with timehorizon. Inflation risk, on the other hand, affects the value of the liabilities through an impact on the cash-flows, which is not affected by time-horizon. In fact, it is only in the case of exceedingly short horizons (e.g., a year) that the relative importance of inflation risk versus interest rate risk becomes substantial within total liability risk. For longer horizon, the inflation risk sensitivity of inflation-linked liabilities is dwarfed by their sensitivity to changes in interest rate. While inflation risk hedging is not a meaningful problem from the short-term perspective, one would expect its importance to increase substantially while the measurement or investment horizon gets close to the liability maturity. Indeed, when the investment horizon
1 - For solution based on commodity investments, one needs to take into account the need to roll-over positions in short-lived futures contracts. 2 - That inflation-linked bonds offer perfect hedging for inflation-linked liabilities is based upon the assumption that liabilities are indexed with respect to price inflation. When liabilities are indexed with respect to wage inflation, no perfect liability-hedging instrument is available since there currently is no fixed-income instrument paying cash-flows linked to wage inflation.
Executive Summary
bonds, which are securities that offer explicit and built-in inflation protection as well as controlled interest rate exposure, but do so at a prohibitive cost, and using securities such as stocks or real assets, which offer higher expected performance but imply a substantially higher risk with respect to the liabilities from a shortterm perspective. This paper argues that a possible way out of dilemma exists, which consists in investing in corporate inflationlinked bonds, which are assets with welldefined interest rate risk exposure, builtin inflation indexation, and which provide a cheaper access to inflation hedging compared sovereign inflation-linked bonds. Credit risk obviously also exists for corporate bonds but at least the presence of credit risk in corporate accounts is well understood and documented. This is in sharp contrast to sovereign credit risk, given that sovereign state accounts are hardly audited. In this context, investment grade corporate bond markets offer better stability and visibility than sovereign bond markets. Besides, using inflation-linked corporate bonds in inflation-hedging portfolios would also provide pension funds with a hedge against changes in regulatory liability value, in the context of the international accounting standards SFAS 87.44 and IAS19.78, which recommend that pension obligations be valued on the basis of a discount rate equal to the market yield on AA corporate bonds.
Welfare Gains Related to InflationLinked Bonds

Investors facing inflation-linked liabilities indeed aim to obtain the highest possible average funding ratio level for
8
given uncertainty, or conversely lowest uncertainty about future funding ratio levels for a given expected value. To achieve this objective, they need access to a risky building block (performanceseeking portfolio, or PSP), to shift the funding ratio distribution towards higher average levels (performance motive), and a safe building block (liability-hedging portfolio, or LHP), to make the funding ratio distribution as narrow as possible (hedging motive). In order to have a better understanding of the total value added by inflation-linked bonds, one thus needs to look at the overall welfare gains, including their positive impact on performance, related to the introduction of these bonds into a portfolio that already contains basic asset classes such as stocks or nominal bonds. This paper precisely proposes a quantitative analysis of the opportunity gains involved in introducing sovereign or corporate inflation-linked bonds within the context of a long-term investor facing inflationlinked liabilities in the presence of interest rate risk and inflation risk. Using formal intertemporal spanning tests, we find that substantial welfare gains are obtained when inflation-linked bonds are introduced, especially over longhorizons. Overall, we find that introducing inflation-linked bonds allows investors to improve investor welfare because of their hedging and performance benefits; hence investors may attain the same welfare (risk-return trade-off) with a lower initial investment when inflationlinked bonds are available compared to investing in stocks and nominal bonds only. These results, which are obtained in a base case with a zero inflation premium and relatively low inflation volatility,
Executive Summary
would be amplified in regions or periods of time with more pronounced inflation uncertainty and positive risk premium. We provide a decomposition in terms of hedging versus performance motive of the marginal gain in investor welfare from introducing inflation-linked bonds. We find that for sovereign inflationlinked bonds, most of the welfare gains come from the improvement in inflationhedging benefits, especially for extremely risk-averse investors who invest mostly in the liability-hedging portfolio. The fraction of the marginal gains due to performance benefits however increases with the assumed inflation risk premium, and can reach values higher than 50% for moderately risk-averse investors. We also provide an analysis of the interactions between the speculative and hedging demands, and how these interactions contribute to enhancing or decreasing indirect utility. In the empirical analysis, we find that these interactions play a very important role in asset allocation decisions. Cross-contributions to investor welfare are substantial and happen to be positive, as expected from the fact that the positive risk premium of inflation-linked bonds held for inflation-hedging purposes within the liability-hedging portfolio improves the overall performance of the portfolio, or equivalently, from the fact that the attractive inflation-hedging properties of inflation-linked bonds held for performance purposes within the performance-seeking portfolio leads to improving the overall inflation-hedging properties of the optimal portfolio.
A Focus on Credit-Sensitive Inflation-Linked Bonds

We also analyze the benefits of long-term asset-liability management inflationlinked bonds issued by corporations, which would contain a credit-sensitive component. We first consider a framework where liabilities are not exposed to credit risk so that marginal benefits, if any, with respect to inflation-linked bonds would come from a higher risk premium. The liability hedging qualities of corporate inflation-linked bonds are in fact inferior to those of sovereign inflation-linked bonds if we assume that credit risk is an additional source of risk that impacts the LHP and not the liabilities. As a consequence, there is no guarantee a priori that the indirect utility achieved with stocks, nominal bonds and corporate inflation-linked bonds will be greater than the indirect utility achieved with stocks, nominal bonds and sovereign inflationlinked bonds. We analyze the trade-off between the increase in performance and the increase in risk induced by the introduction of credit-sensitive inflationlinked bonds, where we consider both the base case value for a low credit spread volatility as well as a higher value for this volatility parameter. It turns out that the gain from investing in corporate inflationlinked bonds instead of sovereign inflation-linked bonds is positive and substantial for low values of risk aversion, especially for long-horizons, whatever the value for credit spread volatility. In other words, the loss of utility that is caused by the decrease in liability-hedging benefits is more than compensated by the gain that follows from the increased performance.
Executive Summary
We also find that the marginal benefits of corporate inflation-linked bonds are even more substantial when the discount rate for liabilities includes a credit risk component, especially for long horizons and low risk aversion. Besides, increases in credit spread volatility leads to higher marginal gains for investors with high risk aversion levels, for whom the welfare gain related to perfect hedging of all risk factors in liability value is more important. For investors with low risk aversion, the speculative motive dominates the hedging motive, and an increase in credit risk volatility translates into a lower welfare gain because of the related decrease in the Sharpe ratio of the inflation-linked bond. Overall, our results suggest that corporate inflation-linked bonds provide substantial benefits to long-term investors, especially those facing inflation-linked liability payments discounted at a credit-sensitive rate.
the associated premium. Secondly, issuing inflation-linked bonds, as opposed to nominal bonds, reduces uncertainty in net profits when revenues (tax revenues for states and municipalities, or operating cash-flows for corporations) are positively related to changes in inflation. In other words, matching the inflation exposure on the asset side and the liability side leads to an increase in firm value (see Martellini and Milhau (2011a) for a formal argument). This paper argues that inflation-linked bonds, in addition to being attractive for issuing corporations, are also attractive for investors such as pension funds facing long-term inflation-linked liabilities. Overall, such investors face a challenge and a dilemma. On the one hand, inflation-linked bonds offer explicit and built-in inflation protection as well as controlled interest rate exposure, but they do so at a prohibitive cost so that most of the benefits are purely related to hedging benefits. On the other hand, securities such as stocks or real assets offer higher expected performance and reasonable inflation-hedging benefits, but they imply a substantially higher risk with respect to the liabilities from a shortterm perspective since their exposure to interest rate risk, which dominates short-term liability risk, is not managed. The results in this paper suggest that a possible way out of dilemma exists, which consists in investing in corporate inflation-linked bonds, which are assets with well-defined interest rate risk exposure, built-in inflation indexation, and which provide a cheaper access to inflation hedging compared sovereign inflation-linked bonds. The benefits of
Conclusion: Reconciling Investors and Issuers Needs

While a dominant fraction of inflationlinked debt is still issued by sovereign states, there has been a recent interest amongst various state-owned agencies, municipalities but also corporations, in particular utility or financial-services companies, to issue inflation-linked bonds. In fact, intuition suggests that if a firms revenues tend to grow with inflation, then having some inflation-linked issuance can be a natural hedge. Issuing inflation-indexed bonds has two main benefits for firms, municipalities or states. First, it leads to a reduction in the cost of debt since the issuing party is selling insurance against inflation and receives
10
Executive Summary
investing in corporate inflation-linked bonds are even more substantial when the regulation imposes the use of a creditsensitive discount rate for liabilities. In this context, it can be expected that the market for corporate inflation-linked bonds will develop substantially in the future. Overall, our results suggest that inflationlinked bonds are ideally suited as liabilityhedging instruments for investors facing inflation-linked liabilities discounted at a AA discount rate. One problem, however, is that the market for these instruments is still under-developed. In this context, one might wonder whether it would be preferable to use corporate nominal bonds, as opposed to inflation-linked sovereign bonds, as substitutes for inflation-linked corporate bonds in case such instruments are not available. Intuitively, credit risk, which directly impacts the discount factor in the same way that interest rate risk does, is expected to dominate inflation risk within liability risk. Besides, the added credit risk premium related to the use of corporate bonds also generates a welfare gain compared to inflation-linked sovereign bonds in terms of performance. In this context, investors facing inflationlinked liabilities discounted at a creditsensitive discount rate, may a priori benefit from using investment grade corporate nominal bonds as substitutes for sovereign inflation-linked bonds as part of their liability hedging portfolios. We leave a thorough analysis of this question as part of future research.
11
Executive Summary
12
1. Introduction
13
1. Introduction
In the presence of increased uncertainty about future price levels in developed economies, inflation hedging has become a concern of critical importance for most investors, including pension funds, which have pension payments that are often indexed with respect to consumer price or wage level indexes, but also for private investors, who consider inflation as a direct threat with respect to the protection of their purchasing power. From an investment solution perspective, the implementation of inflation-hedging portfolios seems to have become relatively straightforward given that inflation-linked bonds issued by various sovereign states can be used to achieve effective inflation hedging. In practice, however, Treasury inflation protected securities (TIPS) suffer from a number of severe drawbacks. First, the market capacity for these inflationlinked bonds is often limited and some large investors are unable to allocate to this asset class as much as would be optimal. A second, related, drawback is that TIPS offer inflation protection at a prohibitive cost. Due to increasing demand from institutional investors, market prices for TIPS have soared in most countries, and real yields have dramatically declined. In a recent paper, Campbell, Shiller, and Viceira (2009) report that while during the 1990s, 10-year inflation-indexed yields averaged about 3.5% in the UK and even exceeded 4% in the US around the turn of the millennium, they both averaged below 2% in the mid-2000s and fell at a level around 1% in early 2008. This massive decline in long-term real interest rates from the 1990s to the 2000s implies that only the wealthiest and best funded pension plans can offer to invest substantial portions of their portfolios
14
to such assets. Finally, and perhaps most importantly looking forward, the increasing concern over sovereign risk has led investors to question the role of sovereign bonds in their portfolio, regardless of whether or not they offer inflation protection. In this context, long-term investors are increasingly turning to other investment vehicles for inflation-hedging purposes. No readily available and extremely effective solution has however been found so far to meet the inflation hedging challenge. On the one hand, dedicated OTC derivatives such as inflation swaps can be used to customize inflation exposure for a long-term investor with inflationlinked liabilities, but such derivativesbased solutions suffer, however, from the presence of counterparty risk, an obvious preoccupation for long horizons. Besides, derivatives-based solutions can hardly be implemented for products intended for the retail or private wealth market. On the other hand, a variety of cash instruments, based on financial asset classes or real asset classes, have been analyzed in terms of their ability to provide attractive inflation-hedging benefits. The results of such empirical investigations, however, have been mixed. For example, it appears that equity investments appear as relatively poor inflation-hedging vehicles from a short-term perspective. Empirical evidence suggests that there is in fact a negative relationship between expected stock returns and expected inflation (see Fama and Schwert (1977), Gultekin (1983) and Kaul (1987) among others), which is consistent with the intuition that higher inflation leads to lower economic activity, thus depressing stock returns (e.g. Fama
1. Introduction
3 - The intuition that higher future ination leads to higher dividends and thus higher long-term returns on stocks (Campbell and Shiller (1988)) can be used to partially justify attractive inationhedging properties for equity investments, but this relationship is not as straightforward as in the presence of explicit ination indexation. In fact, equity investments are likely to be better for wage ination hedging, as opposed to price ination hedging (see Benzoni et al. (2007) for a model with labour income that is co-integrated with dividends).
(1981)). While equity investments have been found to offer better inflation protection over longer horizons (Boudoukh and Richardson (1993) or Schotman and Schweitzer (2000)), these inflation-hedging properties are assessed on a purely statistical basis, and the out-of-sample robustness of these findings remains unclear in the absence of profound economic reasons for the linkage between stock returns and inflation.3 Slightly better results have been obtained with real assets. In particular, commodity prices, which are generally are set in highly competitive auction markets and consequently tend to be more flexible than prices overall, have been found to be leading indicators of inflation in that they are quick to respond to economywide shocks to demand (Gorton and Rouwenhorst (2006)). In the same spirit, it has also been found that commercial and residential real estate provide at least a partial hedge against inflation (see Fama and Schwert (1977), Hartzell et al. (1987) or Rubens et al. (1989)). Even if one is willing to assume that some financial or real assets exhibit relatively attractive inflation-hedging properties, it has to be recognized that investing in asset classes other than fixed-income instruments is extremely risky in the context of liabilityhedging portfolios, where interest rate risk dominates inflation risk from a shortterm perspective (see Martellini and Milhau (2011b)). Overall, a trade-off exists between using inflation-linked bonds, which are securities that offer explicit and built-in inflation protection as well as controlled interest rate exposure, but do so at a prohibitive cost, and using securities such as stocks or real assets, which offer higher expected performance
but imply a substantially higher risk with respect to the liabilities from a short-term perspective. This paper argues that a possible way out of dilemma exists, which consists in investing in corporate inflation-linked bonds, which are assets with well-defined interest rate risk exposure, built-in inflation indexation, and which provide a cheaper access to inflation hedging compared sovereign inflation-linked bonds. Credit risk obviously also exists for corporate bonds but at least the presence of credit risk in corporate accounts is well understood and documented. This is in sharp contrast to sovereign credit risk, given that sovereign state accounts are hardly audited. In this context, it has been argued that investment grade corporate bond markets offer better stability and visibility than sovereign bond markets. Besides, using inflation-linked corporate bonds in inflation-hedging portfolios would also provide pension funds with a hedge against changes in regulatory liability value, in the context of the international accounting standards SFAS 87.44 and IAS19.78, which recommend that pension obligations be valued on the basis of a discount rate equal to the market yield on AA corporate bonds. On the supply side, while a dominant fraction of inflation-linked debt is still issued by sovereign states, there has been a recent interest amongst various state-owned agencies, municipalities but also corporations, in particular utility or financial-services companies, to issue inflation-linked bonds. In fact, intuition suggests that if a firms revenues tend to grow with inflation, then having some inflation-linked issuance can be a natural
15
1. Introduction
hedge (see Martellini and Milhau (2011a) for a formal analysis of this intuition in a continuous-time capital structure model). In fact, by matching the interest rate and inflation exposure of the liabilities to that of the assets, the managers of a firm can contribute to reducing the variability of the cash flows. This has a direct positive consequence in terms of decreasing the probability of default, and consequently decreasing the cost of equity and increasing equity value and Martellini and Milhau (2011a) show that for reasonable parameter values, corporations should issue a non-zero share of inflation-linked bonds. We also find the opportunity costs associated with not issuing IL bonds to be substantial. While recent papers have already documented the benefits of introducing sovereign inflation-linked bonds in investors portfolios (see for example Brennan and Xia (2002), Campbell et al. (2003) or Campbell et al. (2009)), our ambition in this paper is to extend these results to a detailed analysis of the benefits from a portfolio perspective of the introduction in the asset mix of inflation-linked debt issued by municipalities and corporations. We analyze the impact of the introduction of these bonds both from a diversification perspective within performance-seeking portfolios and from an inflation-hedging perspective within liability-hedging portfolios. Corporate bonds have in fact since long been part of institutional investors performance-seeking portfolio, but their merits in liability-hedging portfolios, while intuitively attractive in the case of inflation-linked bonds, remain largely unexplored. Our focus
16
is on long-term investment decisions for both institutional and private investors, where the needs for inflationhedging are most relevant. In the case of corporate inflation-linked bonds, we draw a strong distinction between credit risk and default risk. While the former is an important factor from a short-term perspective, the latter is more relevant in a private wealth management context, where such bonds are typically expected to be held until maturity and the effect of changes in credit ratings can therefore be neglected. More formally, our paper proposes a quantitative analysis of the opportunity gains involved in introducing inflation-linked corporate bonds within the context of a formal intertemporal portfolio selection problem. To achieve this objective, we consider the optimal allocation of a long-term investor facing inflation-linked liabilities in the presence of interest rate risk and inflation risk, and provide a quantitative assessment of the marginal improvement in investor welfare related to the introduction of inflationlinked bonds with or without a credit risk component. We then perform an empirical calibration of the model using a parsimonious sequential maximum likelihood procedure. Using the calibrated parameter values, we compute the term structure of opportunity gains associated with adding inflation-linked corporate bonds. Focusing on welfare gains at various horizons is important because long-term investors have by definition preferences expressed over the value of their portfolio at a long horizon. While inflation risk hedging is dominated by interest rate risk from the short-term perspective, its importance increases substantially when getting close to
1. Introduction
4 - In a recent paper, Brire and Signori (2009) use a dynamic DCC-MVGARCH model for the period 1997-2007 to analyze the diversifying power of (sovereign) ination-linked bonds relative to traditional asset classes, and concluded that these benets have reduced sharply since 2003.
horizon. Indeed, when the investment horizon coincides with the liability horizon, interest rate risk gradually vanishes away to leave inflation risk as the sole source of uncertainty in the liability payment. For reasonable parameter values, we show that welfare losses from introducing corporate inflation-linked bonds in the asset mix are economically significant, especially for high risk aversion levels. These results, which are obtained in a base case with a zero inflation premium and relatively low inflation volatility, would be amplified in regions or periods of time with more pronounced inflation uncertainty and positive risk premium. Similarly, the benefits of corporate inflation linkedbonds are even more substantial when the discount rate for liabilities includes a credit risk component. Beyond their usefulness for liability-hedging purposes, inflation-linked corporate bonds are also found to be useful additions to the performance-seeking component of investors portfolios, due to their positive risk premia and their relatively low correlations with stocks, which makes them attractive for diversification purposes.4 Overall, our results should therefore suggest that corporate inflation-linked bonds provide substantial benefits to long-term investors. The rest of the paper is organized as follows. In Section 2, we introduce the model and focus on inflation-linked bonds in the absence of credit risk. In Section 3, we introduce credit risk in the analysis. Section 4 is dedicated to the empirical calibration of the model and presents an empirical analysis of the marginal benefits of inflation-linked bonds. Section 5 concludes and proposes a number of
suggestions for further research. Technical details are relegated to an appendix.
17
1. Introduction
18
2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM
19

In this first section, we introduce a formal model for an economy with interest rate risk, inflation risk and equity risk, and we measure the benefits of sovereign inflation-indexed bonds for an investor with inflation-linked liabilities.
(2.3)
2.1 Risk Factors

Throughout the paper, uncertainty in the economy is represented by a standard probability space (X, , ). The nominal term structure is assumed to be driven by a single factor taken to be the nominal short-term rate. This variable follows a mean-reverting process (Vasicek, 1977):
5 - Because the nominal term structure is driven by one factor only and the investor can also trade in cash, any bond, with constant or vanishing maturity, can be replicated by dynamic trading in cash and in the constantmaturity bond.
where is a standard -Brownian motion that has constant correlation r with zr. It should be noted that we assume here a constant rate of expected inflation (see e.g. Brennan and Xia (2002), Sangvinatsos and Wachter (2005) for a model with stochastic expected inflation). Throughout Section 2, we assume that the investor is facing liabilities that are represented by an inflation-indexed zero-coupon with maturity L, which means that the investor is committed to pay at date L. Assuming L constant interest rate risk and inflation risk premia, the price of this bond is given by (see Martellini and Milhau (2012)):
where r is a standard -Brownian motion. We assume a constant price of interest rate risk, r . Hence, the price of a nominal zero-coupon bond maturing at date reads:
Any zero-coupon bond can be replicated by a dynamic portfolio strategy involving cash, and a bond index with constant maturity , that evolves as:
In what follows, we let Lt = I(t, L) denote the values of liabilities at time t, and L(Lt) its instantaneous volatility. Throughout the paper, we will assume that the investor can trade in a constant-maturity nominal bond with dynamics given by (2.2), which allows for a perfect hedge of interest rate risk.5 In addition to the constant-maturity bond and cash, the investor can also trade in a stock index S, the price of which evolves as: (2.5)
(2.2)
For notational simplicity, we will write in what follows B for r, and B for D( )r. We further assume that the price index follows a Geometric Brownian Motion:
20
where S is a standard -Brownian motion that has constant correlations rS and S with zr and z.

Finally, we shall sometimes assume that the investor can trade in an inflation-linked bond with a constant-maturity : The volatility vectors of the two zero-coupon bonds are thus:
(2.6) This equality is obtained by writing the dynamics of the decreasing-maturity indexed bond (2.4) and substituting the time-to-maturity L t by the constant in the resulting equation. We will denote with I and I the instantaneous volatility and Sharpe ratio of this bond: The volatility matrix of traded assets, denoted as , is the matrix that collects all the volatility vectors of traded assets. If stocks and nominal bonds are traded, it is given by: while if sovereign indexed bonds are also traded, it becomes: For any set of assets, we can decompose this matrix as (2.7) We have assumed here for simplicity that is constant, but this can easily be relaxed into a maturity t that decreases in time. This would imply that both I and I are time-dependent as well. where is the diagonal matrix that contains the scalar volatilities of the assets, and is the matrix whose columns are the normalized volatility vectors. As a consequence, the matrix is the instantaneous correlation matrix of the assets. We will denote by and the vectors that contain the correlations of traded assets with the risk factors r and , so that:
2.2 Vector Formulation of the Model

The model has three correlated sources of risk: interest rate ( r), realized inflation ( ) and stock price ( S). We assume that they are not redundant, in the sense that none of the three Brownian motions can be written as a linear combination of the other two ones, and rewrite the model in vector form, using a three-dimensional Brownian motion , and three volatility vectors R, and S, such that:
We denote by the vector of Sharpe ratios of traded assets. In the two situations of interest, i.e., when the asset mix consists of stocks and nominal bonds only, or when it contains stocks, nominal bonds and inflation-linked bonds, we have, respectively:
21

Any vector such that at all date t is a price of risk vector. The only price of risk vector that is spanned by the unit volatility matrix is . The other prices of risk vector are those vectors of the form , where for all t. To each of these vectors is associated a stochastic discount factor (SDF) M through: The indirect utility is the conditional expectation of the utility of terminal optimal real wealth:
The following proposition describes the optimal portfolio strategy. Proposition 1 (Optimal Strategy with Sovereign Bonds) The solution to (2.10) can be expressed as:
(2.8)
By definition of the SDF, asset prices multiplied by the SDF follow martingales under (see Duffie (2001)).
2.3 Optimal Portfolio Rule

We let s denote the vector of weights allocated to the risky assets at date s and A be the value of the portfolio. The budget constraint can be written as:
with: the performance-seeking portfolio (PSP)
and the ratio of its Sharpe ratio to its volatility

(2.9) The portfolio choice problem consists in finding the portfolio strategy * that maximizes expected utility from terminal funding ratio as seen from date t: (2.10)
the interest-rate-hedging portfolio
and the beta of interest rate w.r.t. the IRHP

subject to the budget constraint (2.9). Throughout the paper, investors preferences are represented by a CRRA utility function with relative risk aversion :
the inflation-hedging portfolio
22

and the beta of inflation w.r.t. the IHP
2.4 Marginal Impact of InflationLinked Bonds on Investor Welfare

The indirect utility is the maximum expected utility that the investor can achieve given the objective parameters (tradable assets and model parameters), and the subjective parameters (investment horizon and risk aversion). It is thus defined as:
Proof. See Appendix A.1. As shown in Appendix A.1, the optimal portfolio can also be written as a combination of PSP and liability-hedging portfolio (LHP):
with the LHP and the beta of liabilities w.r.t. the LHP being given by:
We thus have two equivalent expressions for the optimal portfolio. The decomposition in PSP, IRHP and IHP building blocks is standard in the literature. On the other hand, the second decomposition, in PSP and LHP, highlights the fact that the investor allocates wealth to two main building blocks, the portfolio that maximizes the Sharpe ratio (PSP) and the portfolio that maximizes the correlation with liabilities (LHP). This result extends the decomposition of Detemple and Rindisbacher (2010) to the case where preferences are expressed over wealth divided by a benchmark, as opposed to nominal wealth.
To measure the specific utility gain of introducing sovereign indexed bonds, we introduce a natural measure of welfare, which we call the marginal LUG (for logarithmic utility gain), which measures the difference between indirect utility achieved with a smaller set of assets versus what is achieved with a larger asset mix equal to augmented with indexed bonds. In the empirical section of this paper (see Section 4), we will study the situations where includes either stocks and nominal bonds, or stocks only. Letting 2 = U{I}, we have, by definition:
The notation LUGt( 2| ) highlights the dependence of the marginal LUG upon the asset mixes and 2. The annualized marginal LUG admits a natural interpretation as an excess performance that would need to be generated by stocks and nominal bonds to compensate for the absence of the inflation-linked bonds when nominal bonds are not traded. To see this, let us assume for instance that inflation-linked bonds are added to stocks and nominal bonds, and let us write the terminal wealth generated
23

by the optimal strategy invested in stocks and nominal bonds when the initial capital invested is . By the budget constraint (2.9), we have: inflation-linked bonds are added to stocks and nominal bonds. A similar presentation could be made if only stocks or nominal bonds were initially present in the asset mix. As shown by Stevens (1998), the specific parameters are obtained by regressing the excess returns on the indexed bond onto the excess returns on stocks and nominal bonds: where and are the optimal weights allocated to the two asset classes, and is the quadratic variation of A. The second expression for AT shows that the annualized marginal LUG is a constant that needs to be added to the returns on stocks, nominal bonds and cash for the indirect utility achieved with these assets to be as high as the indirect utility achieved with stocks, nominal bonds, indexed bonds and cash. As will be shown in Proposition 2 below, the analytical expression of the marginal LUG involves specific parameters of inflationlinked bonds, which are loosely defined as the parameters of the residual of an orthogonal projection of the returns on inflation-linked bonds to the vector space generated by the returns on nominal bonds and stocks. The notion of specific variance has been early introduced by Sharpe (1964), and measures the unsystematic risk on an asset, i.e. the part of risk that is orthogonal to systematic risk factors, where security returns can in general be regarded as factors. The notion of specific expected return has been introduced by Stevens (1998), who shows that it allows for a concise expression of the weights of assets in the PSP. In order to provide a formal definition of the concept, we consider the case where
24
(2.11)
The regression is run across states of the world at each date t, so the moment conditions read
and . The specific expected return is then the alpha of the regression, while the specific variance equals the variance that is left unexplained by the regression model:
where R2 is the R-squared of the regression. In addition to these two specific parameters, we introduce the specific Sharpe ratio, the specific correlation between the indexed bond and interest rate risk, and the specific correlation between the indexed bond and inflation risk:

Appendix A.2 provides expressions for the specific parameters for various asset mixes.6 The following proposition provides an analytical expression for the marginal improvement in investor welfare that results from the introduction of inflationlinked bonds in addition to stocks and nominal bonds. Proposition 2 (Marginal LUG of Sovereign Bonds) The marginal LUG of adding sovereign inflation-indexed bonds to asset mix can be written as: bonds and interest rates, one contribution to the IHP, which depends on the specific correlation I between IL bonds and inflation, as well as three additional cross-contributions. The dependence in the specific Sharpe ratio I is important, because it suggests that inflation-linked bonds will have an impact (positive or negative) on performance in addition to their impact in terms of hedging qualities. As shown by the above proposition, the utility gain does depend on the Sharpe ratio. Proposition 2 also gives sufficient conditions for the indexed bonds to have a zero impact on indirect utility, whatever the investment horizon and the risk aversion. It suffices that all the specific parameters (I , I and Ir) be zero. These conditions can in fact be shown to be also necessary (see Deguest et al. (2012)). When we turn to the empirical analysis below, we shall provide estimates of the magnitudes of the various terms in the decomposition for realistic parameter values. As shown in Appendix A.2, if stocks and nominal bonds are already present in the asset mix, then the specific correlation of indexed bonds with interest rate risk is zero (the intuition being that in our model, interest rate risk is fully spanned by nominal bonds, so inflation-linked bonds cannot improve the correlation between the IRHP and that risk). In this situation, the expression for the marginal LUG reduces to the sum of PSP, IHP and PSP/IHP contributions. In particular, it is independent from the investment horizon. Finally, it is worth noting that as the optimal portfolio weights, the marginal LUG of
with:
6 - It should be noted that when nominal bonds are already present, none of the specic parameters depends on the maturity of the ination-linked bond. Moreover, it can be checked in the proof that the assumption of a constant maturity as opposed to a vanishing maturity is not used.
being respectively the average duration and the average convexity of the price of liabilities with respect to the nominal shortterm rate over the period [t, T].
Proof. See Appendix A.3. Proposition 2 provides interesting insights on the benefits of indexed bonds. It shows that the marginal contribution of inflationlinked (IL) bonds to investor welfare can be decomposed into six terms: one contribution to the PSP, which depends on the specific Sharpe ratio I of IL bonds, one contribution to the IRHP, which depends on the specific correlation Ir between IL
25

indexed bonds can be broken down into contributions of the PSP and the LHP:
(2.12)
where IL is the specific correlation of indexed bonds with liabilities.
26
3. A Formal Analysis of the Benefits of Corporate Inflation-Linked Bonds in ALM
27

We now introduce credit risk, which is a needed ingredient given our intended focus on corporate inflation-indexed bonds. Credit risk is introduced in our reduced-form model through a credit spread, which is formally defined as the difference in yield between a creditsensitive corporate IL bond and an otherwise identical sovereign bond with a zero assumed probability of default. In practice, this credit spread may also contain an adjustment for differences in liquidity in the sovereign versus corporate inflation-linked bond markets.
(3.2)
Hence the risk premium on this bond is stochastic, and so is its Sharpe ratio. Denoting with Ic the volatility of the bond, and with Ic its Sharpe ratio, we have:
(3.3)
7 -These dynamics can also be justied as follows. Let be an equivalent martingale measure such that the price of credit risk is a constant . Then the value of an indexed zero-coupon that pays at date is the expected value of the payoff under discounted at the risk-free rate plus the spread. It can then be shown that this price is an exponential afne function of the short-term rate and the credit spread, where Eic is a function of the time-to-maturity. Applying Itos lemma to this process gives the drift and the volatility of the vanishingmaturity zero-coupon. Replacing the vanishing maturity t by a constant , we obtain the dynamics of the constant-maturity bond.
3.1 Introducing Credit Risk on the Asset Side

In a corporate bond, the credit spread is an additional expected excess return over an otherwise identical sovereign bond. In what follows, we denote the credit spread as t, and we assume that it follows a mean-reverting process with constant volatility: (3.1) Because the credit spread is stochastic, it carries a risk premium, so the total expected return on the corporate bond is equal to the drift of the sovereign bond, plus the spread, plus the risk premium that rewards exposure to credit risk. By analogy with the interest rate risk premium on the sovereign bond in (2.6), we write this risk premium as , where is the price of credit risk per unit of volatility, and is the sensitivity of the bond to credit risk. Finally, the dynamics of the corporate bond read:7
In particular, the Sharpe ratio follows a mean-reverting process, with the same speed of mean reversion as the credit spread, but a different long-term mean and a different volatility:
The vector form of the model has to be modified to account for the presence of credit risk in addition to the three sources of risk that are already present in Section 2 (interest rate, realized inflation and stock price). Uncertainty can be represented by a four-dimensional Brownian motion, which we still denote by z. We also denote by r, , and S the volatility vectors of the various stochastic processes. With these notations, the volatility vector of a corporate indexed bond is: (3.4)
28

As before, the volatility matrix of the traded assets can be decomposed as , with being the matrix of unit volatility vectors and the diagonal matrix of standard deviations. The vector t that collects the Sharpe ratios of traded assets can be written as an affine function of the stochastic credit spread: indexed bonds. The solution to program (2.10) presented in Proposition 1 is nested as a special case of Proposition 3. Proposition 3 (Optimal Strategy with Corporate Bonds) The solution to program (2.10) is given by:
The vector 1 collects the Sharpe ratios of those assets that have constant Sharpe ratios and the constant part in the Sharpe ratio of the corporate indexed bond (see (3.3)), i.e. the term . With stocks, nominal bonds and corporate indexed bonds, we have:
with: the same IRHP and IHP as in Proposition 1;

the performance-seeking portfolio that is state-dependent
with a ratio of its Sharpe ratio to its volatility equal to

If corporate bonds are replaced by sovereign bonds, we are back to the model of Section 2, with:
the credit-risk-hedging portfolio: ,

The spanned price of risk vector is now stochastic and given by , and the other prices of risk are of the form , with for all t. We want to solve program (2.10) in a more general framework than in Section 2. Indeed, we allow not only for stocks and nominal bonds, but also for sovereign or corporate
and the beta of credit spread w.r.t. the CRHP .
29

The functions F2 and F3 are solutions to the following ODEs:
As shown in Appendix A.4, both indirect utility functions are separable in the following sense:
where F1 is solution to an ODE written in the appendix. This factorization of indirect utility allows for an explicit expression for the marginal LUG as a function of the functions F1, F2 and F3 associated with the two asset mixes. This expression will be used in the empirical part of the paper in order to compute the LUG. Because of the stochastic nature of the Sharpe ratio on credit-sensitive IL bonds, it is not possible to provide a decomposition of the marginal welfare gain into contributions of the various portfolios (PSP, IHP, IRHP, CRHP). It should be noted that trading in stocks, nominal bonds and indexed corporate bonds does not allow for a perfect hedge of inflation risk: indeed, as is clear from (3.4), any combination of the three assets that would have nonzero exposure to inflation risk has also non-zero exposure to credit risk. It is therefore impossible to construct from these assets a portfolio that would allow for a separate control of credit and inflation risks. Hence, in contrast with their sovereign counterparts, IL corporate bonds do not allow for a perfect matching of liabilities. One expects this feature to have a negative effect on the marginal LUG, but it is mitigated by the positive effect of the increased performance. In the empirical section of the paper, we evaluate the outcome of the competition between the two effects parameter values
with the initial conditions F2(0) = F3(0) = 0.

Proof. See Appendix A.4. As in Section 2, we can aggregate the demands for the IRHP and IHP into a single demand for the liability-hedging portfolio (LHP), which is the portfolio that is most correlated with liabilities:
The marginal LUG of adding indexed corporate bonds to an asset mix is again defined as the logarithm of the factor by which an initial investment in assets contained in must be multiplied in order to make indirect utility as high as with assets indexed by and corporate bonds. Letting 2 = U {Ic} denote the largest asset mix, and J and J 2 the two indirect utility functions, we thus have that:
30

that have been calibrated to historical data. that the two programs are equivalent: this happens if, and only if, L = T. The following propositions describe the new optimal portfolio strategy. Proposition 4 (Optimal Strategy with Corporate Bonds and Credit-Sensitive Liabilities) The solution to program (3.6) is given by:
3.2 Introducing Credit Risk on the Liability Side

In the previous sections we assumed that the liability process L was given as the price of a sovereign indexed bond paying L at date L. In particular, the payoff was discounted at the risk-free rate. The current regulation actually recommends the use of a different discount rate for liabilities, e.g. the AA rate. In this section, we turn to the implications in terms of portfolio choice of discounting liabilities at rate r + as opposed to r. We denote with Lc the new value of liabilities discounted at the risk-free rate plus the spread. Because liabilities have a fixed maturity date L, they have a decreasing time-to-maturity L t. Hence their dynamics are obtained by substituting the constant with the decreasing quantity L t in (3.2). The volatility vector of liabilities is thus:
with the same PSP, IRHP, IHP and CRHP as in Proposition 3; The function F3 is given in Proposition 3, and H2 is solution to the following ODE:
(3.5)
We still assume that the investor maximizes expected utility of the terminal funding ratio:
with the initial condition H2(0) = 0.

Proof. See Appendix A.5. A second decomposition of the optimal portfolio is obtained by introducing the liability-hedging portfolio, which is the portfolio that maximizes the correlation with the credit-sensitive liability process. This portfolio is thus equal to:
(3.6)
This program looks identical to (2.10), but the denominator LT now contains a credit risk component that was not present in (2.10). It is only if the credit risk component is zero at the horizon
31

with Lc given by (3.5), and the beta of liabilities with respect to this portfolio is . If an indexed corporate bond with the same vanishing maturity as liabilities is traded, then the LHP is fully invested in that bond. With this definition, the optimal portfolio rule can be expressed as:
Appendix A.5 also shows that the indirect utility function can be expressed as:
where H1 is given as the solution to an ODE. This factorization of indirect utility can be used to compute the marginal utility gain from introducing corporate indexed bonds in the asset mix when liabilities are discounted at the risk-free rate plus the spread.
32
4. Empirical Results
33
8 - In a K-factor model, one needs to observe K yields equal to the model-implied yields in order to recover the values of the factors (see Duffee (2002) and Sangvinatsos and Wachter (2005), where K = 3). 9 - The data on these Treasury yields were originally provided by Grkaynak et al. (2007).
In the empirical results we present in this section, we model liabilities as an inflation-linked zero coupon bond with decreasing maturity starting at L = 30 years. We will look at optimal portfolios containing a base asset mix composed of either a stock index, or a stock index and a (nominal) bond index with constant maturity = 10 years. Then we introduce inflation-linked bonds (either sovereign IL bonds that are assumed not to bear credit risk or corporate or municipality IL bonds that contain credit risk) with decreasing maturity starting at I = 30 years, and we measure the corresponding marginal welfare gain. When analyzing corporate inflation-linked bonds, we distinguish between two different frameworks: (i) one framework where liabilities are discounted at the risk-free rate, and (ii) one framework where liabilities are discounted at a credit-sensitive rate.
4.1 Model Calibration and Term Structures of Correlation with Inflation and Liability Returns
We first present the procedure used for calibrating our continuous-time model and the parameter values we obtain. 4.1.1 Parameter Calibration We use nominal zero-coupon yields to calibrate the parameters of the nominal short-term rate. The zero-coupon yield of maturity at date t is defined as the annualized logarithmic yield on a zero-coupon bond issued at date t and maturing at date t + (see (2.1)):
It is clear from this equality that if one observes a yield that is equal to the model-implied yield and if parameters of r are known, then it is possible to recover the value of the short-term rate at each date.8 On the other hand, we need to use a cross-section of data on yields with different maturities in order to identify the price of interest rate risk. We use monthly data on yields of maturities 3 months and 1, 3, 5 and 10 years. The rate of the 3-month T-Bill is available on the website of the Federal Reserve Bank of Saint Louis, and the Treasury yields of constant maturities 1, 3, 5 and 10 years are extracted from the website of the Federal Reserve.9 All yields are available over the period from Aug. 1971-Feb. 2012. We assume that the observed 3-month yield equal to the model-implied one is the yield of maturity 3 months, because it is the shortest maturity available in our data set, and our factor is precisely a short-term rate. Because the model cannot fit exactly more than one yield at all dates, any other observed yield is equal to the model-implied one plus a residual:

34
(4.1)
We assume that the residuals are centered, cross-sectionally and serially uncorrelated, independent from the short-term rate, and normally distributed. Their variance is allowed to depend on the maturity . With this panel of data on zero-coupon yields, all parameters for the short-term rate can be identified. Table 1 shows the estimated parameters, along with the estimated standard errors, obtained by computing the inverse of the Hessian of the log-likelihood function.
10 - A multi-factor version of our model similar to the model of Sangvinatsos and Wachter (2005) would help t both term structures.
Parameters for the price index process can be identified using a single series of inflation. We proxy inflation as the log return on the US Consumer Price Index for All Urban Consumers, available from the Federal Reserve Economic Database at the monthly frequency over the period Jun. 1961-Dec. 2011. Again, estimated parameters are shown in Table 1. In order to estimate the correlation between r and , we need to simultaneously include data on yields and data on CPI in the estimation. Hence we maximize the joint likelihood of observed yields and inflation, taking the parameters of the short-term rate and those of the CPI equal to the point estimates obtained in the previous steps. The inflation risk premium is taken to be equal to 0 in the calibration procedure we do not expect the theoretical model of Section 2.1 to have sufficient flexibility to fit both the nominal and the real term structures.10 For the calibration exercise of the stock index parameters, we assume that the volatility of the stock is a constant S. This assumption has no impact on the computation of indirect utility and derived quantities such as the LUG. Nonetheless, assuming a constant volatility in the calibration procedure allows us to write the likelihood of stock returns analytically. We use monthly returns on the S&P500 taken from Datastream over the period Jan. 1964-Feb. 2012. The parameters S, and S are obtained by maximizing the likelihood of stock returns. All estimates are reported in Table 1. Then we use monthly observations of the CSI AA credit spread index with a maturity equal to 10 years, and obtained from Bloomberg over the period Sep. 2002-Feb. 2012. The
parameters , , and are estimated by maximizing the likelihood of the Vasicek credit spread process. We have considered = 0 since there was no other liquid maturity quotation for the credit spread. All estimates are reported in Table 1. In order to estimate the correlation between r and , we need to include simultaneously data on yields and data on CSI AA credit spreads in the estimation, and in order to estimate the correlation between and , we need simultaneously data on CPI and on CSI AA credit spreads. Finally, we calibrate the remaining correlations, S, Sr, and S by maximizing the joint likelihood of stock returns, observed zerocoupon yields (and either the realized inflations or the credit spreads, depending on the correlation considered) taking all other parameters equal to the point estimates previously obtained. 4.1.2 Inflation Risk Premium As explained previously, we do not calibrate the inflation risk premium by likelihood maximization as we did for the parameters of the nominal shortterm rate, because we do not expect the theoretical model of Section 2.1 to have sufficient flexibility to fit both the nominal and the real term structures. Instead, we seek to identify what should be the break-even value of the inflation risk premium so that the specific risk premium I , as defined in Section 2.4, is zero, and then contrast the value obtained with parameter estimates from the literature. From Proposition 2, we see that taking I = 0 implies that the PSP allocation will remain the same with and without inflation-linked bonds, so that the only benefits from holding these bonds can then be conveniently attributed
35
to their liability-hedging properties, and in particular to the inflation and interest rate risk hedging properties. An expression for the specific Sharpe ratio of the inflation-linked bond index (which can also be interpreted as the specific price of inflation risk) can be obtained from results of Appendix A.2 as:
Hence, a zero specific Sharpe ratio for indexed bonds is equivalent to choosing as:
is wrong, or at least severely incomplete. Indeed, what matters is not the inflationhedging properties of various asset classes, but instead their liability-hedging properties, and the two concepts coincide only at liability maturity. For example, while inflation-linked bonds can perfectly hedge inflation-linked cash flows at any given maturity, they will be shown to exhibit low short-term correlation with changes in inflation. To see this, we compute the log-return at horizon T on stocks (see (2.5)), nominal bonds with constant-maturity = 10 years (see (2.1)), and sovereign inflation-indexed bonds with decreasing maturity starting at 30 years (see (2.4)):11
11 - See Appendix A.6 for details.
With our base case parameter values, the value of the price of inflation risk that yields a zero specific Sharpe ratio is = 6.60%. In accordance with the literature that has found evidence of positive and negative values for (see for example a review of different estimation methods in Grishchenko and Huang (2008)), we simply take = 0% as our neutral base case value, and also consider a positive value = 30% which is in line with the recent literature (e.g. Grishchenko and Huang (2008) and DAmico et al. (2009)). 4.1.3 Term Structure of Correlations with Inflation and Liability Returns What justifies the interest in inflationhedging properties of various asset classes is the intuition that investors with inflation-linked liabilities need to invest in assets that are positively correlated with inflation. In what follows, we argue that this seemingly straightforward intuition
(4.2)
(4.3)
(4.4)
as well as the log-return at horizon T of the liabilities:
The quantities Fi(T), for i = L, S, B, I, are deterministic, so variances and covariances are determined only by the stochastic integrals above. To write the variance of a stochastic integral and the covariance between two stochastic integrals, we use Ito isometry. For instance, the covariance
36
between liabilities and the stock index can be expressed as:
while the variances of stock return and liabilities are given by:
12 - Notice that the perfect correlation obtained between the liabilities and the IL bonds is the result of choosing fixed maturities both for the IL bonds (I = 30 years) and for the liabilities (various L). In the general case when the bond maturity does not match the maturity of liabilities, trading in both the nominal bond and the sovereign inflation-linked bond is needed to match simultaneously the inflation and interest rate risk exposures in the liability portfolio value.
We may also compute the correlation of asset returns with inflation from Equations (4.2) to (4.4) and from the following equality, that follows directly from (2.3):
Figure 1 shows the term structure of correlations of the various asset classes with inflation as a function of horizon, while Figure 2 displays the term structure of correlations of the various asset classes with liabilities as a function of horizon. At maturity, we have LL = L, in which case the correlations in Figures 2 and 1 are equal. On the other hand, the two figures exhibit very different shapes before maturity since Lt t at dates t < L. In other words, we find that liability-hedging properties may be very different from inflation-hedging properties at horizons shorter than the maturity of liabilities. As can be seen in Figure 1, inflation-linked bonds are the only assets that have a perfect correlation with liabilities at all horizons, even though they exhibit low short-term correlation with changes in inflation, as evidenced by the results in Figure 1.12
Intuitively, short-term (instantaneous) liability risk is driven by two main risk factors, namely interest rate risk and inflation risk, and it turns out that for reasonable parameter values, interest rate risk dominates inflation risk so substantially that introducing or removing assets with attractive inflation-hedging properties has little impact on the investors welfare. From a mathematical point, this domination of interest rate risk over inflation risk can be explained by the fact that interest rate risk affects instantaneous liability risk through the impact on the discount factor, an impact that increases linearly with timehorizon (see Equation (2.6) for a formal argument). Inflation risk, on the other hand, affects the value of the liabilities through an impact on the cash-flows, which is not affected by time-horizon (see again Equation (2.6)). In fact, it is only in the case of exceedingly short horizons (e.g., a year) that the relative importance of inflation risk versus interest rate risk becomes substantial within total liability risk. While inflation risk hedging is not a meaningful problem from the shortterm perspective, one would expect its importance to increase substantially while getting close to horizon. Indeed, when the investment horizon coincides with the liability horizon, interest rate risk gradually vanishes away to leave inflation risk remain as the sole source of uncertainty in the liability payment. For the shortest investment horizon considered in the figures (one month), the implied correlation is close to the instantaneous correlation, towards which they would converge in the limit of vanishing maturity. For longer horizons,
37
13 - A negative correlation is not a problem per se for liability-hedging purposes since it can be turned into a positive correlation by shorting the asset.
however, correlations may become very different from the short-term values. For instance, stocks exhibit a correlation with the liabilities close to 0 for short maturities. This means that a strategy entirely invested in stocks will poorly replicate liabilities on the short run. However, when the investment horizon increases, the correlation becomes negative and stays negative until the investment horizon gets close to the liabilities initial maturity.13 In that case, the correlation becomes positive again, but stays close to 0. The situation is very different for nominal bonds. They have good liability-hedging properties at short horizons, reaching correlation close to 1 with the liabilities. However, when the investment horizon increases, their correlation with liabilities decreases, both in absolute and in algebraic value. This means that they become less attractive for liability-hedging purposes when the investment horizon approaches the initial maturity of liabilities. The reason why the correlation between nominal bonds and liabilities is close to 1 at short horizons can be explained by the fact that interest rate risk is dominant in liability risk at such horizons. However, when one approaches the payment date L, inflation risk becomes relatively more important compared to the interest rate risk, and since inflation risk is only partially hedged by nominal bonds, the correlation decreases. As a result, we obtain for example that nominal bonds are negatively correlated with inflation at all horizons lower than 23 years, while they have strongly positive correlation with liabilities on the short run. Stocks also display different correlation patterns with
inflation and liabilities. They are positively correlated with inflation at all horizons, while they have a negative correlation with liabilities at short horizons. Overall, Figures 2 and 1 show that when there is a significant fraction of interest rate risk in liability risk, which is the case for long times-to-maturity, liability hedging is not just a matter of inflation hedging: it is at least equally important to hedge interest rate risk, that is, to match the duration of liabilities. In this context, and emphasizing the difference between liability-hedging and inflation hedging, we find that IL bonds are the only assets that allow for attractive liability hedging properties at all horizons, and as such we expect them to add substantial value in investors liability-hedging portfolios. In order to have a better understanding of the total value added by IL bonds, however, one needs to look at the overall welfare gains, including their positive impact on performance, related to the introduction of these bonds to a portfolio that already contains basic asset classes such as stocks or nominal bonds.
4.2 Introducing Sovereign Inflation-Linked Bonds

In this section, we want to quantify the welfare gains to be expected from introducing sovereign inflation-linked bonds in the asset mix composed of stocks and nominal bonds indexes, and decompose this gain in terms of performance versus hedging motives, as described in Proposition 2.
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4.2.1 Marginal LUG of Introducing Sovereign IL Bonds In Figure 3, we plot the marginal LUG surface as a function of risk aversion and investment horizon for three values for the afore mentioned values of inflation risk premium, and two values of the inflation volatility, the base case value of 1.18% and a 5% value representing a regime of high inflation uncertainty. Our first finding is that the marginal increase in investor welfare can be quite substantial in presence of either high price of inflation risk (i.e., high ) or high inflation uncertainty (). The marginal LUG obtained from the introduction of sovereign inflation-linked bonds in the asset mix composed of stocks and nominal bonds can reach values of 200%. This means when investing in stocks and nominal bonds (in addition to cash), an investor would need an initial wealth of $100 e200% $739 in order to generate the same expected utility as the one obtained when optimally investing $100 in stocks, nominal bonds, and inflationlinked bonds (in addition to cash). We notice a significant difference between the left and right panels of Figure 3, especially for high values of the riskaversion parameter and low values for the inflation premium parameter . Hence, risk-averse investors can benefit from a significantly higher welfare gain if they invest in IL bonds when inflation risk is high, as one would expect. Indeed, the slope of the marginal LUG surfaces as a function of is much steeper when inflation volatility is high. This illustrates the inflation-hedging properties of IL bonds, as we will see in the decomposition of the marginal welfare gain into various contributions. We also notice that the
shape of the surface strongly depends on the choice of the inflation risk premium. For low values ( = 6.60%) of the inflation risk premium, the marginal LUG appears to be slowly increasing with respect to the risk aversion , and with respect to investment horizon T. On the other hand, for high values of inflation risk premium, ( = 30%), we observe that the marginal LUG is significantly higher for low levels of risk aversion. This is explained by the fact that higher values of are more attractive to the less risk-averse investor who has a higher allocation to the PSP, while welfare gains obtained for highly risk-averse investor mostly come from the hedging properties of IL bonds. In order to better understand the influence of the performance versus hedging motives in the marginal LUG, we use in what follows the decomposition of the marginal LUG0(I, B, S|S, B), and will present each of the marginal contributions in the following sections. 4.2.2 Marginal Impact on Performance The relative contribution of the performance-seeking-portfolio (PSP) to the marginal LUG implied by the introduction of the sovereign IL bonds is represented in Figure 4. First, we observe that for = 6.60%, the PSP contribution is equal to 0. This result was expected since the choice of was precisely made so that the specific price of inflation risk I = 0, which implies that the allocation to IL bonds in the PSP is zero. We also notice that the relative contribution of the PSP is increasing in the price of inflation risk and decreasing in the risk aversion. These findings can be explained by the fact that the contribution of the PSP to the marginal LUG equals
39
, a quantity that is increasing in and decreasing in . Second, we observe that when the inflation volatility increases, then the relative contribution of the PSP to the marginal LUG is concentrated towards the least risk-averse investors, i.e., towards the investors for which the values of are close to 1. This result shows that, when inflation risk is high, most of the value added by inflationlinked bonds for risk-averse investors comes from their hedging benefits. Finally, we notice that the PSP contribution to the marginal LUG is independent of the investment horizon T, which was already observed from Proposition 2 when stocks and bonds belong to the initial asset mix, and when the maturity of IL bonds was constant. This comes from the fact that both the marginal LUG0(I, B, S|S, B) and the PSP contribution to the marginal LUG, equal to , increase linearly with the investment horizon. Therefore, the ratio of both quantities is constant with respect to the investment horizon T. 4.2.3 Marginal Impact on Hedging Following Proposition 2, we know that the contribution of hedging motives to the marginal LUG implied by the introduction of IL bonds can be decomposed into three terms: the inflation hedging contribution, the interest rate hedging contribution, and the contribution coming from the interaction between these two hedging portfolios. These three terms, when gathered all together represent the contribution of the liability hedging portfolio (LHP). It should be noted that the relative contribution of the IRHP is equal to 0 when the initial asset mix already contains the nominal bond. This comes from the perfect interest rate hedging
40
properties of the nominal bond index in our framework. Indeed, by considering a one-factor Vasicek model, we implicitly assume that rB = 1. In this context, the introduction of IL bonds cannot improve interest rate hedging since an IRHP 100% invested in nominal bonds already shows a perfect anti-correlation with changes in interest rates. Therefore, the contribution of the liability hedging portfolio illustrated in Figure 5 is reduced to the contribution of the inflation-hedging portfolio. This allows us to focus on inflation risk hedging properties of IL bonds, which play a critical importance for inflation-linked liabilities, especially over long horizons. Moreover, we notice that the relative contribution of the IHP is significant, explaining the total marginal LUG for a choice of such that the sovereign IL bonds do not impact the PSP. Indeed, the choice of = 6.60% is such that the full benefit of IL bonds comes from its inflation hedging property, and not from its possible performance. We notice that when increases, there is a transfer of contribution from the inflation hedging motive towards the performance motive, as expected. Furthermore, we observe that the benefits of IL bonds are zero for the logarithmic investor ( = 1) which has no interest in the hedging benefits of the various assets. Then, we note that the relative contribution of the IHP increases with respect to the risk aversion , which is the opposite of what we observed previously for the PSP contribution. This is explained by the fact that the multiplicative factor in the IHP contribution is an increasing function of , which was not the case of the multiplicative factor in the PSP contribution . Finally, when
the inflation risk increases, which is represented by considering an inflation volatility of 5%, and illustrated in the three right panels of Figure 5, we observe that the level of the relative contribution of the IHP increases. This was already suggested by Figure 4, when we observed that the relative contribution of the PSP decreased after an increase of . 4.2.4 Cross-Contribution of Hedging and Performance To obtain a better understanding of the interaction between the performance and the hedging motives, we present in Figure 6 the cross-contribution of the PSP and the liability hedging portfolio LHP, for the three values of , and the two regimes of inflation volatility. As explained previously, we recall that the contribution of the IRHP is equal to 0 because the nominal bond index already allows for a perfect hedge of interest rate risk. Therefore, the cross-contribution between the PSP and the IRHP should also be equal to 0. By construction, the contribution of inflation-linked bonds to the PSP is equal to 0 for the lower value of = 6.60% This implies that 100% of the marginal LUG comes from hedging the residual fraction of inflation risk that could not be hedged away by the stock and nominal bond indexes. Increasing from6.60% to 0% has an impact on both the PSP component and the crossterm between the PSP and the LHP, which is reduced here to the inflation hedging portfolio (IHP). This contribution is positive, as expected from the fact that the positive risk premium of inflation-linked bonds held for inflation-hedging purposes within the IHP improves the overall performance of the portfolio, or equivalently, from the
fact that the attractive inflation-hedging properties of inflation-linked bonds held for performance purposes within the PSP leads to improving the overall inflationhedging properties of the optimal portfolio. Increasing further to 30% produces a surface with similar shape but higher level, due to the increased specific Sharpe ratio of inflation-indexed bonds which transfers some of the IHP contribution to the PSP contribution. Another remark is that the crosscontribution of the PSP and the IHP remains constant in time. Indeed, the time-dependency of the marginal LUG comes from the average duration and average convexity factors that impact the IRHP term. Since the contribution of inflation-linked bonds to the IRHP is zero when the initial asset mix contains the nominal bond index, we then obtain that the marginal LUG (and in particular the PSP, the IHP and the cross-contribution between the PSP and the IHP) are linear functions of the investment horizon T.14
14 - This remark is no longer valid if we were to consider the cross-contributions to the marginal LUG of adding IL bonds to the stock index. In that case, the additional gain from improvement in hedging against interest rate risk would induce a dependency on the investment horizon T. 15 - In general sovereign IL bonds may also be exposed to credit risk.
4.3 Marginal Benefits of Corporate Inflation-Linked Bonds

In this section, we analyze the benefits of using corporate IL bonds that are exposed to credit risk, but exhibit at the same time higher risk premium, instead of the sovereign IL bonds that we introduced in Section 4.2.15 Since we compare the welfare obtained with two different asset mixes 1 = U {Is} and 2 = U {IC} where includes stocks and nominal bonds, we need to introduce a slightly modified version of marginal LUG. It was previously defined as the welfare gained from the addition of a new asset class,
41
where now we are looking at the welfare gained from substituting an asset class with another. Letting J 1 and J 2 denote the two indirect utility functions, we naturally define the welfare gain from substituting Is with IC in the asset mix as:
the indirect utility achieved with stocks, nominal bonds and sovereign IL bonds. We analyze the trade-off between increase in performance and increase in risk induced by the introduction of creditsensitive IL bonds in Figure 7, where we consider both the base case value for credit spread volatility = 0.71% (right panels) as well as an augmented value = 5% (left panel). It turns out that the gain from investing in corporate IL bonds instead of sovereign IL bonds, denoted LUG0(S,B, Ic|S,B, Is), appears to be positive and substantial for low values of risk aversion whatever the value for credit spread volatility. The improvement in the PSP contribution intuitively comes from the magnitude of the credit spread, which implies an increase in the Sharpe ratio for inflation-linked bonds, as illustrated in (3.3). Moreover, the fact that the marginal LUG is positive shows that the loss of utility that is caused by the inability to hedge all risk factors perfectly is more than compensated by the gain that follows from the increased performance. 4.3.2 Marginal Impact for Liabilities Discounted at a Credit-Sensitive Rate So far, we have always considered liabilities discounted at a risk-free rate. We expect that further benefits from corporate inflation-linked bonds would be obtained in a context where the discount rate on liabilities includes a credit risk adjustment. In order to quantify these additional benefits, we need to isolate the credit risk benefits of corporate IL bonds from its Sharpe ratio increase illustrated in Figure 7. In order to do so, we compute in Figure 8, the difference between the marginal LUG related to using corporate IL bonds instead
The following sections are devoted to the quantification of this welfare gain within two different frameworks: (i) one framework where liabilities are discounted at the risk-free rate, and (ii) one framework where liabilities are discounted at a creditsensitive rate. 4.3.1 Marginal Impact for Liabilities Discounted at the Risk-free Rate First of all, we consider a framework where liabilities are not exposed to credit risk. Given that liabilities are only subject to interest rate and inflation risks, our intuition is that corporate IL bonds will not provide a better hedge against liability risk than their sovereign counterparts, so that marginal benefits, if any, will come from their possibly higher risk premium. The liability hedging qualities of corporate IL bonds are in fact inferior to those of sovereign IL bonds because credit risk is an additional source of risk that impacts the LHP and not the liabilities. In other words, investors have access to three risky investment vehicles (stocks, nominal bonds, and corporate IL bonds), while they are facing four sources of risks (interest rate risk, equity risk, inflation risk and credit risk). As a consequence, there is no guarantee a priori that the indirect utility achieved with stocks, nominal bonds and corporate IL bonds will be greater than
42
of sovereign IL bonds (denoted by LUG0(S, B, Ic|S, B, IS)) in two different cases: (i) when liabilities are exposed to credit risk, and (ii) when liabilities are not exposed to credit risk, like in Figure 7. Figure 8 first shows that the shape of the marginal LUG gained from hedging the credit risk is not sensitive to a change in the specific price of the inflation risk I. This is because the analysis focuses on the impact of changes in the discount rate used for pricing liability streams, which is not sensitive to the choice for the inflation risk premium. If we look at all the left panels of Figure 8, we first notice that the marginal gain from hedging credit risk is relatively small, with a value that remains below 3%. This is mostly due to the fact that the calibrated credit spread volatility is small = 0.71% compared to the interest rate volatility r = 1.96% or inflation volatility = 1.18%. To test for the impact of an increase in credit risk uncertainty, we also consider a situation where credit risk volatility is higher than the base case value, and taken to be 5% (see right panels in Figure 8). In this case, the marginal gain increases by a factor around 10, which shows that in high credit risk regimes, the benefits from hedging credit risk with liability streams becomes more important. This illustrates another important hedging quality of corporate IL bonds over sovereign IL bonds. Finally, we observe in each panel of Figure 8 that for values of risk aversion close to 1, i.e., for investor who are not concerned with hedging risks, then the marginal benefit of credit risk hedging is 0, as it should. Also, for investment horizons that match the initial maturity of liabilities, which is of 30 years, then the marginal benefits
of corporate IL bonds over sovereign IL bonds are insensitive to the choice of the discount rate of liabilities. Indeed, the influence of the discount rate disappears when approaching the maturity date for liability payments. We finally analyze the total welfare gain of investing in corporate IL bonds, given that the investor already holds the stock and the nominal bond indexes, and given that the liabilities are exposed to credit spread risk. Figure 9 shows the marginal LUG obtained from adding corporate IL bonds to the same asset mix given that liabilities are discounted with a creditsensitive rate. We find that the marginal gains are typically substantial, and particularly large for long horizons and low risk aversion. This statement holds true regardless of whether one uses the base case value for credit risk volatility or the high value for credit risk volatility. When comparing the right to the left panels in Figure 9, we find that increases in credit spread volatility leads to higher marginal gains for investors with high risk aversion levels, for whom the welfare gain related to perfect hedging of all risk factors in liability value is more important. For investors with low risk aversion, the speculative motive dominates the hedging motive, and an increase in credit risk volatility translates into a lower welfare gain because of the related decrease in the Sharpe ratio of the IL bond.
43
44
5. Conclusion
45
5. Conclusion
While a dominant fraction of inflationlinked debt is still issued by sovereign states, there has been a recent interest amongst various state-owned agencies, municipalities but also corporations, in particular utility or financial-services companies, to issue inflation-linked bonds. In fact, intuition suggests that if a firms revenues tend to grow with inflation, then having some inflation-linked issuance can be a natural hedge. Issuing inflation-indexed bonds has two main benefits for firms, municipalities or states. First, it leads to a reduction in the cost of debt since the issuing party is selling insurance against inflation and receives the associated premium. Secondly, issuing inflation-linked bonds, as opposed to nominal bonds, reduces uncertainty in net profits when revenues (tax revenues for states and municipalities, or operating cash-flows for corporations) are positively related to changes in inflation. In other words, matching the inflation exposure on the asset side and the liability side leads to an increase in firm value (see Martellini and Milhau (2011a) for a formal argument). This paper shows that inflation-linked bonds are also attractive to investors, in addition to being attractive to issuers. Investors facing inflation-linked liabilities indeed aim to obtain the highest possible average funding ratio level for given uncertainty, or conversely lowest uncertainty about future funding ratio levels for a given expected value. To achieve this objective, they need access to a risky building block (PSP), to shift the funding ratio distribution towards higher average levels (performance motive), and a safe building block (LHP), to make the funding
46
ratio distribution as narrow as possible (hedging motive). This paper proposes an empirical analysis of the opportunity gains involved in investing in inflation-linked bonds for long-term investors facing inflation-linked liabilities. Using formal intertemporal spanning tests, we find that substantial welfare gains are obtained, especially over long-horizons. Introducing inflation-linked bonds allows investors to improve investor welfare because of their hedging and performance benefits; hence investors may attain the same welfare (risk-return trade-off) with a lower initial investment when inflation-linked bonds are available compared to investing in stocks and nominal bonds only. Even more substantial utility gains are obtained in situations where the regulatory value for investors liabilities contains a credit risk adjustment. Overall, investors endowed with inflationlinked objectives or liabilities face a challenge and a dilemma. On the one hand, inflation-linked bonds offer explicit and built-in inflation protection as well as controlled interest rate exposure, but they do so at a prohibitive cost so that most of the benefits are purely related to hedging benefits. On the other hand, securities such as stocks or real assets offer higher expected performance and reasonable inflation-hedging benefits, but they imply a substantially higher risk with respect to the liabilities from a shortterm perspective since their exposure to interest rate risk, which dominates shortterm liability risk, is not managed. This paper argues that a possible way out of dilemma exists, which consists in investing in corporate inflation-linked bonds, which are assets with well-defined interest rate
5. Conclusion
risk exposure, built-in inflation indexation, and which provide a cheaper access to inflation hedging compared to sovereign inflation-linked bonds. Since inflationlinked corporate bonds are attractive from both the issuers and the investors perspective, it can be expected that a more active market for these instruments will develop in the future. In the meantime, one might wonder whether it would be preferable to use nominal corporate bonds, as opposed to inflation-linked sovereign bonds, as substitutes for inflation-linked corporate bonds in case such instruments are not available. Intuitively, credit risk, which directly impacts the discount factor in the same way that interest rate risk does, is expected to dominate inflation risk within liability risk. Besides, the added credit risk premium related to the use of corporate bonds also generates a welfare gain compared to inflation-linked sovereign bonds in terms of performance. In this context, investors facing inflation-linked liabilities discounted at a credit-sensitive discount rate, may a priori benefit from using investment grade corporate nominal bonds as substitutes for sovereign inflation-linked bonds as part of their liability hedging portfolios. More generally, we leave for further research a thorough analysis of the benefits of standard corporate bonds without inflation indexation for long-term investors facing nominal or inflationlinked liabilities.
47
5. Conclusion
48
Appendices
49
Appendices
A. Proofs of Propositions
This appendix contains the proofs of the results given in the paper. A.1 Proof of Proposition 1 We solve (2.10) using the duality (or martingale) technique in incomplete markets of He and Pearson (1991). The static form of the optimization program reads: , subject to where M* is the minimax SDF, which is specific to the investor. The first-order optimality condition in the static program implies that the optimal wealth is for some Lagrange multiplier . Hence the optimal wealth process: (A.1)
where we have set
. We note that the dynamics of M*L reads:
We search for the minimax price of risk vector vector, so that Gs is given in closed form by: in the form of a deterministic
Applying Itos lemma to (A.1), we obtain the volatility vector of A*: From the budget constraint (2.9), we have , hence: (A.2)
Expanding the volatility vector of liabilities as L(L s) = D(L s)r + and defining the performance-seeking portfolio, the interest-rate hedging portfolio and the inflation-hedging portfolio as written in the proposition, we obtain:
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Appendices
In order to compute , and , we use the following relationships, that hold for any portfolio strategy w. The expected excess return on wealth and the variance of wealth are given by:
and the covariance between wealth and liabilities is:
Using the expressions
and
, we arrive at:
Hence the expression for the optimal portfolio written in the proposition. In order to verify that (A.1) by the matrix is indeed deterministic, we note that multiplying both sides of implies:
hence (note that N is the matrix of the residual of the orthogonal projection onto the columns of U). This shows that is a deterministic vector process. The decomposition of w* as a combination of PSP and LHP is obtained by writing , and introducing the liability-hedging portfolio (note that this portfolio is time-dependent because of the decreasing maturity of liabilities). The beta of liabilities w.r.t. LHP is obtained by the same computation as the beta of interest rate risk w.r.t. IRHP:
A.2 Expressions for Specific Parameters We first treat the case of a generic asset mix = {S} and = {S,B}.
, and then consider the special cases
A.2.1 Generic Case Denote with St the vector of prices of assets contained in , and with t the vector of multivariate betas of the indexed bond with respect to these assets. We can write the general form of regression equation (2.11) as:
(A.3)
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We let denote the volatility matrix of assets indexed by , which can be written as = UV by (2.7). Taking conditional covariances with the returns on assets indexed by in both sides of (A.3), we get: hence (A.4) is the vector of correlations between assets in the universe The vector the indexed bond, a vector that we denote with RI. Hence: Then, taking variances in both sides of (A.3), we get: which implies the following expression for the specific variance: We also let denote the vector of Sharpe ratios of assets indexed by residual of (A.3) is: . Then the (A.5) and
Take the conditional expectation in both sides of the second equality. This implies the specific expected excess return: (A.6) and the specific Sharpe ratio: (A.7)
The covariance between the residual and interest rate risk is:
where Rr is the vector of correlations between the assets indexed by and interest rate risk. Hence the specific correlation of the indexed bond with interest rate risk: (A.8)
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The correlation between the indexed bond and interest rate risk satisfies . By the same computation, we obtain the specific correlation between the indexed bond and inflation risk: with . (A.9)
A.2.2 Special Cases When = {S}, the specific parameters of the indexed bond are:
Recall that the instantaneous correlation between the stock and the indexed bond is given by: We now turn to the case where = {S, B}. Let denote the volatility matrix, = (S B). The vector of multivariate betas (see (A.4)) can be expressed . We then note that can be decomposed as = 1 M1, where 1 =(S r) and . Hence:
with e2 = (0, 1)'. (A.5) implies that the specific variance is
, so that:
Expliciting the inverse of
(which is a 2 2 matrix) and using the fact that , we obtain:
53
Appendices
The specific expected excess return (A.6) can be rewritten as:
We note that the vector . Hence: can be expressed as , where
The specific correlation of the indexed bond with inflation risk is obtained by similar computations:
Note that the specific correlation with interest rate risk is zero because this risk is already fully spanned by the nominal bond. A.3 Proof of Proposition 2 We first establish an explicit expression for indirect utility, and then use it in order to derive the expression for the marginal LUG.
A.3.1 Expression for Indirect Utility With the notations of appendix A.1, we have:
which, from (A.1), implies that , so that:
. Gt is given by (A.2) with
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Computing the integrals within the exponential, we obtain:
To obtain another expression for indirect utility, we expand the volatility vector of liabilities as . This substitution gives:
(A.10)
A.3.2 Expression of Marginal LUG Let us denote with G and the values of Gt when the asset mix is respectively. The definition of the marginal LUG can be rewritten as:
or
which implies that:
We let denote the correlation matrix of assets and 2 be the correlation matrix of the extended asset mix 2 = U {I}. We distinguish in the same way the vectors of Sharpe ratios , and the vectors of correlations with risk factors and . Then, we obtain from (A.10):
(A.11)
55
Appendices
Denoting with have:
the vector of correlations of the indexed bond with assets
, we
The blockwise inverse of this matrix is given by: Let us focus on the first term in the decomposition of the marginal LUG; the blockwise inversion formula implies that: Using (A.7), we get: The second and third terms in the right side of (A.11) are handled in a similar way:
For the fourth term in the right side of (A.11), we have, still using the blockwise inversion formula:
Using the expressions of the specific correlation (A.8), we arrive at: Repeating the computation for the remaining two terms in the right side of (A.11), we obtain: This concludes the proof of Proposition 2. For decomposition (2.12), we note that the specific correlation of indexed bonds with liabilities and the squared specific correlation are given by:
Aggregating the contributions of IRHP and IHP and the cross-contribution of IRHP/IHP leads to the contribution of LHP, and aggregating the cross-contributions of IRHP/PSP and IHP/PSP gives the cross-contribution of LHP/PSP.
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A.4 Proof of Proposition 3 The optimal wealth process has the same form as with sovereign indexed bonds, but with a different minimax SDF: with (A.12)
. We search for a representation of G under the form
Applying Itos lemma to (A.12), we obtain the volatility vector of A*:
(A.13) Introducing the credit-risk-hedging portfolio as defined in the proposition and writing that , we obtain the expression for the optimal portfolio written in the proposition. We again apply Itos lemma to (A.12) in order to obtain the drift of A*:
57
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Because M*A* is a martingale, this drift must be equal to leads to the following equality:
, which
(A.14) Multiplying both sides of (A.13) by the matrix , we obtain:
Substituting this expression into the right side of (A.14), we get a quadratic function of s, with time-dependent coefficients. Since it must be zero at any date s, for any value of s, the coefficients of s and and the intercept must be zero at all date s. Writing that the coefficient of is zero leads to:
Writing that the coefficient of s is zero implies:
Finally, the condition of a zero intercept implies:
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Appendices
The initial conditions in the ODEs are F1(0) = F2(0) = F3(0) = 0 because GT must be equal to 1 for any value of T. The ODEs for F2 and F3 written in the proposition are obtained by changing s into T s. Factorization (A.12) of the optimal wealth process implies that the indirect utility function is separable in the following sense:
A.5 Proof of Proposition 4 As in Proposition 3, the optimal wealth can be written in terms of the minimax SDF M* and the Lagrange multiplier :
The process G is still defined by an exponential quadratic function of :
, and we conjecture that G is
Using Itos lemma, we obtain the volatility vector and the drift of A*:
and:
59
Appendices
We then follow the same technique as in Appendix A.4: we make use of the requirement that is spanned by the volatility matrix to obtain the following expression for :
Then we write the condition . The left-hand side of this equation can be written as a quadratic function of s, with deterministically timedependent coefficients that can be expressed in terms of the functions H1, H2 and H3. This quadratic function must be zero at any date s in [t, T], for any value of s. Hence the intercept of the quadratic function, and the coefficients of s and must be zero at any date, which leads to the following three conditions:
The terminal conditions are H1(0) = H2(0) = H3(0) = 0. Because H3 is solution to the same ODE as F3 with the same initial condition, H3 is equal to F3. A.6 Model-Implied Correlations with Liability We have to justify equations (4.2) to (4.4). Let us, for example, compute the log-return of stocks:
60
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Moreover, the dynamics of the log price of the zero-coupon bond of maturity T is:
Hence:
Integrating from 0 to T, we obtain:
Letting FS(T) denote the sum of the first two terms in the right side, we obtain (4.2). In order to compute the log-returns of the other asset classes, we can proceed in a similar way.
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Table 1: Maximum Likelihood Estimates of Base Case Model Parameters. Estimates for parameter values have been obtained by maximizing the log-likelihood (except , and S) of monthly observations on US market. Standard deviations have been computed by taking the square roots of diagonal elements of the inverse of Fishers information matrix.
B Tables and Figures
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Figure 1: Term structures of correlation of asset classes with realized inflation. The figure displays the correlations of log-returns on four asset classes with realized inflation at different horizons. The asset classes considered are 10-year constant-maturity nominal bonds (B), stocks (S), and fixed-maturity sovereign inflation-linked bonds (I) with initial maturity I = 30 years. These correlations are computed from the parameters of table 1.
Figure 2: Term structures of correlation of asset classes with liabilities. The figure displays the correlations of log-returns on four asset classes with liabilities at different horizons. The asset classes considered are 10-year constant-maturity nominal bonds, stocks, and fixed-maturity sovereign inflation-linked bonds with initial maturity I = 30 years. The liability portfolio is a fixed-maturity inflation-indexed bond with initial maturity L equal to 1, 10, 20, 30 years that is not exposed to credit risk. These correlations are computed from the parameters of table 1.
63
Appendices
Figure 3: Marginal gain from adding sovereign inflation-linked bonds to stocks and nominal bonds. This figure displays two sets of three panels representing the marginal Logarithmic Utility Gain (LUG) obtained from adding the sovereign inflation-linked bond to a base case asset mix composed of the stock index and the nominal bond, and denoted as LUG0(I, S, B, | S, B). For each marginal LUG, two different values for the inflation volatility have been considered: 1.18% (left panels), and 5% (right panels), and three different values for the price of inflation risk per unit of volatility, , have been considered: 30% (high), 0% (base case), and 6.60% (low). The marginal LUG is computed for various levels of risk aversion in [1; 50] and various investment horizons T between 1 and 30 years.
64
Appendices
Figure 4: Performance contribution to the marginal gain from adding sovereign inflation-linked bonds to stocks and nominal bonds. This figure displays two sets of three panels representing the performance contribution (PSP) to the marginal Logarithmic Utility Gain (LUG) obtained from adding the sovereign inflation-linked bond to a base case asset mix composed of the stock index and the nominal bond, and denoted as LUG0(I, S, B, | S,B). For each marginal LUG, two different values for the inflation volatility have been considered: 1.18% (left panels), and 5% (right panels), and three different values for the price of inflation risk per unit of volatility, , have been considered: 30% (high), 0% (base case), and 6.60% (low). The marginal LUG is computed for various levels of risk aversion in [1; 50] and various investment horizons T between 1 and 30 years.
65
Appendices
Figure 5: Liability hedging contribution to the marginal gain from adding sovereign inflation-linked bonds to stocks and nominal bonds. This figure displays two sets of three panels representing the liability hedging contribution (LHP) to the marginal Logarithmic Utility Gain (LUG) obtained from adding the sovereign inflation-linked bond to a base case asset mix composed of the stock index and the nominal bond, and denoted as LUG0(I, S, B, | S, B). For each marginal LUG, two different values for the inflation volatility have been considered: 1.18% (left panels), and 5% (right panels), and three different values for the price of inflation risk per unit of volatility, , have been considered: 30% (high), 0% (base case), and 6.60% (low). The marginal LUG is computed for various levels of risk aversion in [1; 50] and various investment horizons T between 1 and 30 years.
66
Appendices
Figure 6: Cross-contribution (PSP/LHP) to the marginal gain from adding sovereign inflation-linked bonds to stocks and nominal bonds. This figure displays two sets of three panels representing the cross-contribution of the performance and liability hedging portfolios to the marginal Logarithmic Utility Gain (LUG) obtained from adding the sovereign inflation-linked bond to a base case asset mix composed of the stock index and the nominal bond, and denoted as LUG0(I, S, B, | S, B). For each marginal LUG, two different values for the inflation volatility have been considered: 1.18% (left panels), and 5% (right panels), and three different values for the price of inflation risk per unit of volatility, , have been considered: 30% (high), 0% (base case), and 6.60% (low). The marginal LUG is computed for various levels of risk aversion in [1; 50] and various investment horizons T between 1 and 30 years.
67
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Figure 7: Impact on utility gain of choosing corporate instead of sovereign inflation-linked bonds if liabilities are discounted at risk-free rate. This figure displays two sets of three panels representing the marginal Logarithmic Utility Gain (LUG) obtained from substituting the sovereign inflation-linked bond with the corporate inflation-linked bond in a base case asset mix composed of the stock index and the nominal bond. For each marginal LUG, two different values for the credit spread volatility have been considered: 0.71% (left panels), and 5% (right panels), and three different values for the price of inflation risk per unit of volatility, , have been considered: 30% (high), 0% (base case), and 6.60% (low). The marginal LUG is computed for various levels of risk aversion in [1; 50] and various investment horizons T between 1 and 30 years.
68
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Figure 8: Impact of the liabilities credit risk exposition on marginal welfare gain. This figure displays two sets of three panels representing the difference between two marginal Logarithmic Utility Gains: (i) obtained from substituting the sovereign inflation-linked bond with the corporate inflation-linked bond when liabilities are exposed to credit risk, and (ii) obtained from substituting the sovereign inflation-linked bond with the corporate inflation-linked bond when liabilities are not exposed to credit risk. For each marginal LUG, two different values for the credit spread volatility have been considered: 0.71% (left panels), and 5% (right panels), and three different values for the price of inflation risk per unit of volatility, , have been considered: 30% (high), 0% (base case), and 6.60% (low). The marginal LUG is computed for various levels of risk aversion in [1; 50] and various investment horizons T between 1 and 30 years.
69
Appendices
Figure 9: Overall gain from adding corporate inflation-linked bonds to stocks and nominal bonds. This figure displays two sets of three panels representing the marginal Logarithmic Utility Gain (LUG) obtained from adding the corporate inflation-linked bond to a base case asset mix composed of the stock index and the nominal bond, and denoted as LUG0(I, S, B, | S, B) (right panels). Liabilities are exposed to credit risk and discounted at the AA rate. For each marginal LUG, two different values for the credit spread volatility have been considered: 0.71% (left panels), and 5% (right panels), and three different values for the price of inflation risk per unit of volatility, , have been considered: 30% (high), 0% (base case), and 6.60% (low). The marginal LUG is computed for various levels of risk aversion in [1; 50] and various investment horizons T between 1 and 30 years.
70
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Figure 10: Impact on utility gain of choosing corporate nominal bonds instead of sovereign inflation-linked bonds. This figure displays two sets of three panels representing the marginal Logarithmic Utility Gain (LUG) obtained from substituting the sovereign inflation-linked bond with the corporate nominal bond in a base case asset mix composed of the stock index and the nominal bond. Liabilities are exposed to credit risk and discounted at the AA rate. For each marginal LUG, two different values for the credit spread volatility have been considered: 0.71% (left panels), and 5% (right panels), and three different values for the price of inflation risk per unit of volatility, , have been considered: 30% (high), 0% (base case), and 6.60% (low). The marginal LUG is computed for various levels of risk aversion in [1; 50] and various investment horizons T between 1 and 30 years.
71
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72
References
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References
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References
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About Rothschild & Cie
77
About Rothschild & Cie
Rothschild has been involved in investment banking since its beginning over two hundred years ago when Rothschild businesses were established in the principal cities of Europe at the end of the 18th century. Today, the Rothschild Group is one of the worlds leading financial advisory and asset management organisations which is family controlled and independent. It has an established network of offices around the world with more than 2000 people in over 40 countries (including the USA, UK, France, Switzerland, Singapore, China,). Rothschild Global Financial Advisory is involved in providing impartial and expert M&A and strategic advice as well as financing and restructuring advice across the range of equity and debt capital markets. Rothschild & Cie Gestion is the asset management arm of the Rothschild Group in France. Rothschild & Cie Gestion manages EUR 22bn in assets and offers a diversified product range, with expertises in equities (focusing on European equities), bonds (including govies, Euro credit and European convertibles), balanced management, and long-only as well as alternative multi-management.
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About EDHEC-Risk Institute
79
Founded in 1906, EDHEC is one of the foremost international business schools. Accredited by the three main international academic organisations, EQUIS, AACSB, and Association of MBAs, EDHEC has for a number of years been pursuing a strategy of international excellence that led it to set up EDHEC-Risk Institute in 2001. This institute now boasts a team of 90 permanent professors, engineers and support staff, as well as 48 research associates from the financial industry and affiliate professors..
The Choice of Asset Allocation and Risk Management

EDHEC-Risk structures all of its research work around asset allocation and risk management. This strategic choice is applied to all of the Institute's research programmes, whether they involve proposing new methods of strategic allocation, which integrate the alternative class; taking extreme risks into account in portfolio construction; studying the usefulness of derivatives in implementing asset-liability management approaches; or orienting the concept of dynamic core-satellite investment management in the framework of absolute return or target-date funds.
Six research programmes have been conducted by the centre to date: Asset allocation and alternative diversification Style and performance analysis Indices and benchmarking Operational risks and performance Asset allocation and derivative instruments ALM and asset management These programmes receive the support of a large number of financial companies. The results of the research programmes are disseminated through the EDHEC-Risk locations in Singapore, which was established at the invitation of the Monetary Authority of Singapore (MAS); the City of London in the United Kingdom; Nice and Paris in France; and New York in the United States. EDHEC-Risk has developed a close partnership with a small number of sponsors within the framework of research chairs or major research projects: Core-Satellite and ETF Investment, in partnership with Amundi ETF Regulation and Institutional Investment, in partnership with AXA Investment Managers Asset-Liability Management and Institutional Investment Management, in partnership with BNP Paribas Investment Partners Risk and Regulation in the European Fund Management Industry, in partnership with CACEIS Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation, in partnership with CME Group
Academic Excellence and Industry Relevance

In an attempt to ensure that the research it carries out is truly applicable, EDHEC has implemented a dual validation system for the work of EDHEC-Risk. All research work must be part of a research programme, the relevance and goals of which have been validated from both an academic and a business viewpoint by the Institute's advisory board. This board is made up of internationally recognised researchers, the Institute's business partners, and representatives of major international institutional investors. Management of the research programmes respects a rigorous validation process, which guarantees the scientific quality and the operational usefulness of the programmes.
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Asset-Liability Management in Private Wealth Management, in partnership with Coutts & Co. Asset-Liability Management Techniques for Sovereign Wealth Fund Management, in partnership with Deutsche Bank The Benefits of Volatility Derivatives in Equity Portfolio Management, in partnership with Eurex Structured Products and Derivative Instruments, sponsored by the French Banking Federation (FBF) Optimising Bond Portfolios, in partnership with the French Central Bank (BDF Gestion) Asset Allocation Solutions, in partnership with Lyxor Asset Management Infrastructure Equity Investment Management and Benchmarking, in partnership with Meridiam and Campbell Lutyens Investment and Governance Characteristics of Infrastructure Debt Investments, in partnership with Natixis Advanced Modelling for Alternative Investments, in partnership with Newedge Prime Brokerage Advanced Investment Solutions for Liability Hedging for Inflation Risk, in partnership with Ontario Teachers Pension Plan The Case for Inflation-Linked Corporate Bonds: Issuers and Investors Perspectives, in partnership with Rothschild & Cie Solvency II, in partnership with Russell Investments Structured Equity Investment Strategies for Long-Term Asian Investors, in partnership with Socit Gnrale Corporate & Investment Banking
The philosophy of the Institute is to validate its work by publication in international academic journals, as well as to make it available to the sector through its position papers, published studies, and conferences. Each year, EDHEC-Risk organises three conferences for professionals in order to present the results of its research, one in London (EDHEC-Risk Days Europe), one in Singapore (EDHEC-Risk Days Asia), and one in New York (EDHEC-Risk Days North America) attracting more than 2,500 professional delegates. EDHEC also provides professionals with access to its website, www.edhec-risk.com, which is entirely devoted to international asset management research. The website, which has more than 58,000 regular visitors, is aimed at professionals who wish to benefit from EDHECs analysis and expertise in the area of applied portfolio management research. Its monthly newsletter is distributed to more than 1.5 million readers.
EDHEC-Risk Institute: Key Figures, 2011-2012
Nbr of permanent staff Nbr of research associates Nbr of afliate professors Overall budget External nancing Nbr of conference delegates Nbr of participants at research seminars Nbr of participants at EDHEC-Risk Institute Executive Education seminars
90 20 28 13,000,000 5,250,000 1,860 640 182
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The EDHEC-Risk Institute PhD in Finance

The EDHEC-Risk Institute PhD in Finance is designed for professionals who aspire to higher intellectual levels and aim to redefine the investment banking and asset management industries. It is offered in two tracks: a residential track for high-potential graduate students, who hold part-time positions at EDHEC, and an executive track for practitioners who keep their full-time jobs. Drawing its faculty from the worlds best universities, such as Princeton, Wharton, Oxford, Chicago and CalTech, and enjoying the support of the research centre with the greatest impact on the financial industry, the EDHEC-Risk Institute PhD in Finance creates an extraordinary platform for professional development and industry innovation.
School of Management to set up joint certified executive training courses in North America and Europe in the area of investment management. As part of its policy of transferring knowhow to the industry, EDHEC-Risk Institute has also set up ERI Scientific Beta. ERI Scientific Beta is an original initiative which aims to favour the adoption of the latest advances in smart beta design and implementation by the whole investment industry. Its academic origin provides the foundation for its strategy: offer, in the best economic conditions possible, the smart beta solutions that are most proven scientifically with full transparency in both the methods and the associated risks.
Research for Business

The Institutes activities have also given rise to executive education and research service offshoots. EDHEC-Risk's executive education programmes help investment professionals to upgrade their skills with advanced risk and asset management training across traditional and alternative classes. In partnership with CFA Institute, it has developed advanced seminars based on its research which are available to CFA charterholders and have been taking place since 2008 in New York, Singapore and London. In 2012, EDHEC-Risk Institute signed two strategic partnership agreements with the Operations Research and Financial Engineering department of Princeton University to set up a joint research programme in the area of risk and investment management, and with Yale
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EDHEC-Risk Institute Publications and Position Papers (2010-2013)
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EDHEC-Risk Institute Publications (2010-2013)

2013
Calamia, A., L. Deville, and F. Riva. Liquidity in european equity ETFs: What really matters? (March). Deguest, R., L. Martellini, and V. Milhau. Hedging versus insurance: Long-horizon investing with short-term constraints (February). Amenc, N., F. Goltz, N. Gonzalez, N. Shah, E. Shirbini and N. Tessaromatis. The EDHEC european ETF survey 2012 (February). Padmanaban, N., M. Mukai, L . Tang, and V. Le Sourd. Assessing the quality of asian stock market indices (February). Goltz, F., V. Le Sourd, M. Mukai, and F. Rachidy. Reactions to A review of corporate bond indices: Construction principles, return heterogeneity, and fluctuations in risk exposures (January). Joenvr, J., and R. Kosowski. An analysis of the convergence between mainstream and alternative asset management (January). Cocquemas, F. Towards better consideration of pension liabilities in european union countries (January). Blanc-Brude, F. Towards efficient benchmarks for infrastructure equity investments (January).
2012
Arias, L., P. Foulquier and A. Le Maistre. Les impacts de Solvabilit II sur la gestion obligataire (December). Arias, L., P. Foulquier and A. Le Maistre. The Impact of Solvency II on Bond Management (December). Amenc, N., and F. Ducoulombier. Proposals for better management of non-financial risks within the european fund management industry (December). Cocquemas, F. Improving Risk Management in DC and Hybrid Pension Plans (November). Amenc, N., F. Cocquemas, L. Martellini, and S. Sender. Response to the european commission white paper "An agenda for adequate, safe and sustainable pensions" (October). La gestion indicielle dans l'immobilier et l'indice EDHEC IEIF Immobilier d'Entreprise France (September). Real estate indexing and the EDHEC IEIF commercial property (France) index (September). Goltz, F., S. Stoyanov. The risks of volatility ETNs: A recent incident and underlying issues (September). Almeida, C., and R. Garcia. Robust assessment of hedge fund performance through nonparametric discounting (June). Amenc, N., F. Goltz, V. Milhau, and M. Mukai. Reactions to the EDHEC study Optimal design of corporate market debt programmes in the presence of interest-rate and inflation risks (May).
84

Goltz, F., L. Martellini, and S. Stoyanov. EDHEC-Risk equity volatility index: Methodology (May). Amenc, N., F. Goltz, M. Masayoshi, P. Narasimhan and L. Tang. EDHEC-Risk Asian index survey 2011 (May). Guobuzaite, R., and L. Martellini. The benefits of volatility derivatives in equity portfolio management (April). Amenc, N., F. Goltz, L. Tang, and V. Vaidyanathan. EDHEC-Risk North American index survey 2011 (March). Amenc, N., F. Cocquemas, R. Deguest, P. Foulquier, L. Martellini, and S. Sender. Introducing the EDHEC-Risk Solvency II Benchmarks maximising the benefits of equity investments for insurance companies facing Solvency II constraints - Summary - (March). Schoeffler, P. Optimal market estimates of French office property performance (March). Le Sourd, V. Performance of socially responsible investment funds against an efficient SRI Index: The impact of benchmark choice when evaluating active managers an update (March). Martellini, L., V. Milhau, and A.Tarelli. Dynamic investment strategies for corporate pension funds in the presence of sponsor risk (March). Goltz, F., and L. Tang. The EDHEC European ETF survey 2011 (March). Sender, S. Shifting towards hybrid pension systems: A European perspective (March). Blanc-Brude, F. Pension fund investment in social infrastructure (February). Ducoulombier, F., Lixia, L., and S. Stoyanov. What asset-liability management strategy for sovereign wealth funds? (February). Amenc, N., Cocquemas, F., and S. Sender. Shedding light on non-financial risks a European survey (January). Amenc, N., F. Cocquemas, R. Deguest, P. Foulquier, Martellini, L., and S. Sender. Ground Rules for the EDHEC-Risk Solvency II Benchmarks. (January). Amenc, N., F. Cocquemas, R. Deguest, P. Foulquier, Martellini, L., and S. Sender. Introducing the EDHEC-Risk Solvency Benchmarks Maximising the Benefits of Equity Investments for Insurance Companies facing Solvency II Constraints - Synthesis -. (January). Amenc, N., F. Cocquemas, R. Deguest, P. Foulquier, Martellini, L., and S. Sender. Introducing the EDHEC-Risk Solvency Benchmarks Maximising the Benefits of Equity Investments for Insurance Companies facing Solvency II Constraints (January). Schoeffler.P. Les estimateurs de march optimaux de la performance de limmobilier de bureaux en France (January).
2011
Amenc, N., F. Goltz, Martellini, L., and D. Sahoo. A long horizon perspective on the cross-sectional risk-return relationship in equity markets (December 2011).
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Amenc, N., F. Goltz, and L. Tang. EDHEC-Risk European index survey 2011 (October). Deguest,R., Martellini, L., and V. Milhau. Life-cycle investing in private wealth management (October). Amenc, N., F. Goltz, Martellini, L., and L. Tang. Improved beta? A comparison of indexweighting schemes (September). Le Sourd, V. Performance of socially responsible investment funds against an Efficient SRI Index: The Impact of Benchmark Choice when Evaluating Active Managers (September). Charbit, E., Giraud J. R., F. Goltz, and L. Tang Capturing the market, value, or momentum premium with downside Risk Control: Dynamic Allocation strategies with exchange-traded funds (July). Scherer, B. An integrated approach to sovereign wealth risk management (June). Campani, C. H., and F. Goltz. A review of corporate bond indices: Construction principles, return heterogeneity, and fluctuations in risk exposures (June). Martellini, L., and V. Milhau. Capital structure choices, pension fund allocation decisions, and the rational pricing of liability streams (June). Amenc, N., F. Goltz, and S. Stoyanov. A post-crisis perspective on diversification for risk management (May). Amenc, N., F. Goltz, Martellini, L., and L. Tang. Improved beta? A comparison of indexweighting schemes (April). Amenc, N., F. Goltz, Martellini, L., and D. Sahoo. Is there a risk/return tradeoff across stocks? An answer from a long-horizon perspective (April). Sender, S. The elephant in the room: Accounting and sponsor risks in corporate pension plans (March). Martellini, L., and V. Milhau. Optimal design of corporate market debt programmes in the presence of interest-rate and inflation risks (February).
2010
Amenc, N., and S. Sender. The European fund management industry needs a better grasp of non-financial risks (December). Amenc, N., S, Focardi, F. Goltz, D. Schrder, and L. Tang. EDHEC-Risk European private wealth management survey (November). Amenc, N., F. Goltz, and L. Tang. Adoption of green investing by institutional investors: A European survey (November). Martellini, L., and V. Milhau. An integrated approach to asset-liability management: Capital structure choices, pension fund allocation decisions and the rational pricing of liability streams (November). Hitaj, A., L. Martellini, and G. Zambruno. Optimal hedge fund allocation with improved estimates for coskewness and cokurtosis parameters (October).
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Amenc, N., F. Goltz, L. Martellini, and V. Milhau. New frontiers in benchmarking and liability-driven investing (September). Martellini, L., and V. Milhau. From deterministic to stochastic life-cycle investing: Implications for the design of improved forms of target date funds (September). Martellini, L., and V. Milhau. Capital structure choices, pension fund allocation decisions and the rational pricing of liability streams (July). Sender, S. EDHEC survey of the asset and liability management practices of European pension funds (June). Goltz, F., A. Grigoriu, and L. Tang. The EDHEC European ETF survey 2010 (May). Martellini, L., and V. Milhau. Asset-liability management decisions for sovereign wealth funds (May). Amenc, N., and S. Sender. Are hedge-fund UCITS the cure-all? (March). Amenc, N., F. Goltz, and A. Grigoriu. Risk control through dynamic core-satellite portfolios of ETFs: Applications to absolute return funds and tactical asset allocation (January). Amenc, N., F. Goltz, and P. Retkowsky. Efficient indexation: An alternative to cap-weighted indices (January). Goltz, F., and V. Le Sourd. Does finance theory make the case for capitalisation-weighted indexing? (January).
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EDHEC-Risk Institute Position Papers (2010-2013)

2012
Till, H. Who sank the boat? (June). Uppal, R. Financial Regulation (April). Amenc, N., F. Ducoulombier, F. Goltz, and L. Tang. What are the risks of European ETFs? (January).
2011
Amenc, N., and S. Sender. Response to ESMA consultation paper to implementing measures for the AIFMD (September). Uppal, R. A Short note on the Tobin Tax: The costs and benefits of a tax on financial transactions (July). Till, H. A review of the G20 meeting on agriculture: Addressing price volatility in the food markets (July).
2010
Amenc, N., and V. Le Sourd. The performance of socially responsible investment and sustainable development in France: An update after the financial crisis (September). Amenc, N., A. Chron, S. Gregoir, and L. Martellini. Il faut prserver le Fonds de Rserve pour les Retraites (July). Amenc, N., P. Schoefler, and P. Lasserre. Organisation optimale de la liquidit des fonds dinvestissement (March). Lioui, A. Spillover effects of counter-cyclical market regulation: Evidence from the 2008 ban on short sales (March).
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Notes
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Notes
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For more information, please contact: Carolyn Essid on +33 493 187 824 or by e-mail to: carolyn.essid@edhec-risk.com EDHEC-Risk Institute 393 promenade des Anglais BP 3116 - 06202 Nice Cedex 3 France Tel: +33 (0)4 93 18 78 24 EDHEC Risk InstituteEurope 10 Fleet Place, Ludgate London EC4M 7RB United Kingdom Tel: +44 207 871 6740 EDHEC Risk InstituteAsia 1 George Street #07-02 Singapore 049145 Tel: +65 6438 0030 EDHEC Risk InstituteNorth America 1230 Avenue of the Americas Rockefeller Center - 7th Floor New York City - NY 10020 USA Tel: +1 212 500 6476 EDHEC Risk InstituteFrance 16-18 rue du 4 septembre 75002 Paris France Tel: +33 (0)1 53 32 76 30 www.edhec-risk.com

The Benefits of IIBs in Long Term Investment Decisions

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An EDHEC-Risk Institute Publication

with the support of

An EDHEC-Risk Institute Publication

About the Authors

An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication

Introduction: The Costs and Benefits of Inflation Hedging

substantial estimation risk and parameter uncertainty.1

Inflation Hedging versus Liability Hedging

Welfare Gains Related to InflationLinked Bonds

A Focus on Credit-Sensitive Inflation-Linked Bonds

An EDHEC-Risk Institute Publication

Conclusion: Reconciling Investors and Issuers Needs

An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication

suggestions for further research. Technical details are relegated to an appendix.

An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication

2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM

An EDHEC-Risk Institute Publication

2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM

2.1 Risk Factors

2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM

2.2 Vector Formulation of the Model

An EDHEC-Risk Institute Publication

2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM

2.3 Optimal Portfolio Rule

with: the performance-seeking portfolio (PSP)

and the ratio of its Sharpe ratio to its volatility

the interest-rate-hedging portfolio

and the beta of interest rate w.r.t. the IRHP

the inflation-hedging portfolio

An EDHEC-Risk Institute Publication

2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM

2.4 Marginal Impact of InflationLinked Bonds on Investor Welfare

2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM

2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM

2. A Formal Analysis of the Benefits of Sovereign Inflation-Linked Bonds in ALM

where IL is the specific correlation of indexed bonds with liabilities.

An EDHEC-Risk Institute Publication

3. A Formal Analysis of the Benefits of Corporate Inflation-Linked Bonds in ALM

An EDHEC-Risk Institute Publication

3. A Formal Analysis of the Benefits of Corporate Inflation-Linked Bonds in ALM

3.1 Introducing Credit Risk on the Asset Side

An EDHEC-Risk Institute Publication

3. A Formal Analysis of the Benefits of Corporate Inflation-Linked Bonds in ALM

with: the same IRHP and IHP as in Proposition 1;

with a ratio of its Sharpe ratio to its volatility equal to

the credit-risk-hedging portfolio: ,

and the beta of credit spread w.r.t. the CRHP .

An EDHEC-Risk Institute Publication

3. A Formal Analysis of the Benefits of Corporate Inflation-Linked Bonds in ALM

with the initial conditions F2(0) = F3(0) = 0.

An EDHEC-Risk Institute Publication

3. A Formal Analysis of the Benefits of Corporate Inflation-Linked Bonds in ALM

3.2 Introducing Credit Risk on the Liability Side

with the initial condition H2(0) = 0.

An EDHEC-Risk Institute Publication

3. A Formal Analysis of the Benefits of Corporate Inflation-Linked Bonds in ALM

An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication

11 - See Appendix A.6 for details.