Abstract:
The aim of this paper is to develop an optimal long-term bond
investment strategy which can be applied to real market situations. This
paper employs Merton’s intertemporal framework to accommodate the features
of a stochastic interest rate and the time-varying dynamics of bond
returns.The long-term investors encounter a partial information problem where
they can only observe the market bond prices but not the driving factors of the
variability of the interest rate and the bond return dynamics.With the assumption
of Gaussian factor dynamics, we are able to develop an analytical solution
for the optimal long-term investment strategies under the case of full information.
To apply the best theoretical investment strategy to the real market
we need to be aware of the existence of measurement errors representing the
gap between theoretical and empirical models. We estimate the model based
on data for the German securities market and then the estimation results are
employed to develop long-term bond investment strategies. Because of the
presence of measurement errors, we provide a simulation study to examine
the performance of the best theoretical investment strategy. We find that the
measurement errors have a great impact on the optimality of the investment
strategies and that under certain circumstance the best theoretical investment strategies may not perform so well in a real market situation. In the simulation
study, we also investigate the role of information about the variability of the
stochastic interest rate and the bond return dynamics. Our results show that
this information can indeed be used to advantage in making sensible long-term
investment decisions.
