Outline of the Framework.

An autoregressive equation is used to model the inflation rates in collaboration with a Regime Switching model. Two distinct equations are obtained representing the corresponding mean, variance and autoregressive coefficient associated with each regime. An n-period non-recombining binomial tree is then constructed with the Markov transition probabilities for the inflation rate. The terminal node values are computed using recursion (as the process is autoregressive). The expectation is then taken over all the terminal nodes with the transition probabilities being the probability measure. The resulting value is the expected inflation rate, n periods from now condi- tional on the current regime. A similar process is done to find the expected inflation rate variance, n periods from now conditional on the current regime.

The next step is to find the nominal expected returns of all the assets in the asset pool. This is done using geometric returns from prior data. The covariances of the assets to each other are then computed. The expected returns are perturbed by an inflation factor. This factor is the inflation Beta of the asset, computed using regression, multiplied by the expected inflation rate generated. The objective function follows the form of a single-factor model and has a noise term that is computed using the expected inflation variance solved for.

The quadratic program formulated is then solved for and the resulting weights, for investment in each asset, are returned. Rebalancing over time is performed but with an additional transaction cost constraint that ensures the impracticality of dramatic changes in allocation cannot occur.

Steps for generating graphs:

1. Navigate to Capstone-MATLAB
2. Add to Path(Selected Folders and Subfolders) MS REGRESS FEX 1.08, Symbol Files, Main- ProgramFiles
3. In CSV Files, add nyse SP to path
4. Open the file “a.m” and modify parameters as desired. The comments above the file explain the parameters and how to choose them
5. run “a.m”

Steps for viewing all MATLAB workspace variables:

1. Complete steps 1-3 in “Steps for generating graphs”
2. In “a.m”, comment out all the current code, and uncomment the line “run create inflation hedged portfolio.m”
3. In “create inflation-hedged portfolio.m”, delete the function header and its corresponding end
4. Uncomment the section at the beginning
5. Define variables as desired and run “a.m”