References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

Appendix 3.A: Derivation of the Exact Solution When j 1. . . . . . . . . . . . . . 62 Appendix 3.B: Derivation of the Approximate Results . . . . . . . . . . . . . . . . . . . 64

T HIS PAPER FINDS THE OPTIMAL consumption and dynamic asset allocation of stocks,bonds and derivatives for long-term investors in contrast to the standard optimal dynamic asset allocation strategies involving only stocks and bonds. The chapter explores

and attempts to understand the effect of introducing a non-redundant derivative security

on an already-existing stock-in particular, on the volatility of stock returns. Instead of a

single-period (two-date) result, we also delve into the optimal intertemporal consumption

as well as dynamic asset allocation strategies under a stochastic investment opportunity set.