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Optimal Consumption and Portfolio Choice under Ambiguity for a Mean-reverting Risk Premium in Complete Markets

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  • Hening Liu

    (Accounting and Finance, Manchester Business School, University of Manchester)

Abstract

This paper explicitly solves, in closed form, the optimal consumption and portfolio choice for an ambiguity averse investor in a Merton-type two assets economy where a risk premium follows a mean-reverting process. The investor's preferences are represented by the recursive multiple priors utility model developed by Chen and Epstein (2002). The investor's utility depends on both intermediate consumption and terminal wealth. Under the assumption of complete markets, I use the martingale method to solve the dynamic optimization problem in continuous time. I find that ambiguity can decrease the optimal consumption-to-wealth ratio, the intertemporal hedging demand and the optimal portfolio allocation, but magnifies the importance of hedging demand in the optimal portfolio allocation. In addition, ambiguity also increases riskless savings.

Suggested Citation

  • Hening Liu, 2013. "Optimal Consumption and Portfolio Choice under Ambiguity for a Mean-reverting Risk Premium in Complete Markets," Annals of Economics and Finance, Society for AEF, vol. 14(1), pages 21-52, May.
    • Handle: RePEc:cuf:journl:y:2013:v:14:i:1:n:2:liu
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    References listed on IDEAS

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    1. Epstein, Larry G. & Miao, Jianjun, 2003. "A two-person dynamic equilibrium under ambiguity," Journal of Economic Dynamics and Control, Elsevier, vol. 27(7), pages 1253-1288, May.
    2. Hening Liu, 2011. "Dynamic portfolio choice under ambiguity and regime switching mean returns," Post-Print hal-00781344, HAL.
    3. Peter Klibanoff & Massimo Marinacci & Sujoy Mukerji, 2005. "A Smooth Model of Decision Making under Ambiguity," Econometrica, Econometric Society, vol. 73(6), pages 1849-1892, November.
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    6. Wachter, Jessica A., 2002. "Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(1), pages 63-91, March.
    7. Liu, Hening, 2011. "Dynamic portfolio choice under ambiguity and regime switching mean returns," Journal of Economic Dynamics and Control, Elsevier, vol. 35(4), pages 623-640, April.
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    Cited by:

    1. Haijun Wang & L. Steven Hou, 2015. "Robust Consumption and Portfolio Choice with Habit Formation, the Spirit of Capitalism and Recursive Utility," Annals of Economics and Finance, Society for AEF, vol. 16(2), pages 393-416, November.

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    More about this item

    Keywords

    Ambiguity; Mean-reverting; Portfolio choice; Recursive multiple priors;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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