Essays on habit formation and inflation hedging

The thesis consists of four chapters. Chapter 1 reviews recent contributions on habit formation in the literature and investigates its implications for investors. Chapter 2 revisits the “Floor-Leverage” rule for investors with ratchet consumption preference proposed by Scott and Watson (2011). It shows that the original Floor-Leverage rule is infeasible and has a high probability of bankruptcy and that a relatively inexpensive option strategy can hedge against such bankruptcy risk. Chapter 3 investigates the optimal portfolio and consumption policies for a finite-horizon investor in a life-cycle model with habit formation and inflation. It considers two types of habit formation, real habit formation and nominal habit formation, and shows that the effects of inflation on the optimal strategy are marginal under the former, but substantial under the latter. Chapter 4 studies portfolio choice for a finite-horizon investor whose labor income is cointegrated with inflation. This long-run relationship is crucial for the inflation-hedging property of human capital and the overall portfolio strategy.