This paper provides a model of dynamic asset allocation strategy for investors with mortgage liability facing time-varying interest rates. We adopt the Duffie-Epstein (1992b) formulation to describe investors' preferences by a recursive utility function defined over consumption flows and use perturbation methods to get linear approximate solutions in continuous-time. We show that the long-term investor will have a positive intertemporal hedging demand on bonds coming from pure changes in interest rates. We provide other distinguishable hedging components in the equity portfolio and long-term real bonds of the optimal dynamic asset allocation for hedging investors' mortgage liability in this paper.
Key words: Stochastic investment opportunities, mortgage liability, intertemporal model.