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HEDGING THE STANDARD OF LIVING VIA COST OF LIVING INDEX FUTURES RAINER SCHULZ Ph.D. Program “Applied Microeconomics” Humboldt University and Free University, Berlin SFB 373 rschulz@wiwi.hu-berlin.de November 2000 Abstract People dislike inflation because inflation erodes the real value of future nominal income and wealth. Adjustment of future nominal values via a cost of living index is an appropriate way to handle the problem of real income risk. Nonetheless an important aspect needs more discussion: If markets existed in which ’real income risks’ could be traded—would a rational individual always voluntarily purchase protection against such risk? A model is developed to shed some light on this aspect. It shows that the optimal behaviour depends—as expected— on the cost of protection and the risk preferences of the individual. JEL Codes: D11, D8 Keywords: Cost of Living Index, Futures Markets 1 Introduction There is an ongoing discussion in many OECD countries about the future of public pension programs. The existing pension arrangements are far too costly in many countries and future payments of programs seem to be uncertain. There are several proposals under discussion to reform the current public pension arrangements. A currently widely debated proposal in Germany picks up the foreseeable financial restrictions of the public pension plan in the future and wants to encourage greater “Eigenvorsorge” (i.e., private pension schemes). Even though I would like to thank Stefano G. Athanasoulis, Irwin L. Collier, Franz Hubert, Fran