Interest Rate Uncertainty and Strategic Asset Allocation with Borrowing and Short Sales Constraints

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The paper provides the solution to a dynamic portfolio problem of an investor who faces borrowing and short sales constraints in a setting with stochastic interest rates. The multi-asset dynamic problem is reduced to a constrained quadratic optimization problem which is similar to the well-known problem studied in static mean-variance portfolio theory. As an example and illustration of the general results, the paper focuses on the closed-form portfolio solution of a borrowing constrained long-term investor who cannot perfectly replicate very long-term real bonds and instead uses other securities (e.g. stocks) to hedge real interest risk. The efficiency loss due to, e.g., such a borrowing constraint is addressed.