The Welfare Gain from the Introduction of Indexed Bonds

I examine the welfare gain from the introduction of indexed bonds in zero net supply. I show that trade in indexed bonds enables investors to reallocate existing economic risks in a mutually beneficial manner. The aggregate gain from the introduction of a safe asset is proportional to the variance of the minimum-variance portfolio formed from the risky assets and to the heterogeneity of investors' risk preferences. In an economy with nominal but not indexed bonds, the welfare loss from inflation uncertainty is lowest when inflation is most closely correlated with real returns on other assets. Contrary to popular intuition, the introduction of indexed bonds may reduce saving. Copyright 1993 by Ohio State University Press.