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Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies

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Author Info
Kogan, Leonid
Uppal, Raman
Abstract

In this article, we show how to analyse analytically the equilibrium policies and prices in an economy with a stochastic investment opportunity set and incomplete financial markets, when agents have power utility over both intermediate consumption and terminal wealth, and face portfolio constraints. The exact local comparative statistics and approximate but analytical expression for the portfolio policy and asset prices are obtained by developing a method based on perturbation analysis to expand around the solution for an investor with log utility. We then use this method to study a general equilibrium exchange economy with multiple agents who differ in their degree of risk aversion and face borrowing constraints. We characterize explicitly the consumption and portfolio policies and also the properties of asset returns. We find that the volatility of stock returns increases with the cross-sectional dispersion of risk aversion, with the cross-sectional dispersion in portfolio holdings, and with the relaxation of the constraint on borrowing. Moreover, tightening the borrowing constraint lowers the risk-free interest rate and raises the equity premium in equilibrium.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3306.

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Date of creation: Apr 2002
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Handle: RePEc:cpr:ceprdp:3306

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Related research
Keywords: asset allocation; asymptotic analysis; borrowing constraints; incomplete markets; stochastic investment opportunities;

Find related papers by JEL classification:
D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  1. Sanford J. Grossman & Jean-Juc Vila, . "Optimal Dynamic Trading with Leverage Constraints," Rodney L. White Center for Financial Research Working Papers 36-89, Wharton School Rodney L. White Center for Financial Research.
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    Other versions:
  4. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
    Other versions:
  5. 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(01), pages 63-91, March. [Downloadable!]
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  7. Albert Marcet & Kenneth J. Singleton, 1990. "Equilibrium Asset Prices and Savings of Heterogeneous Agents in the Presence of Incomplete Markets and Portfolio Constraints," Economics Working Papers 319, Department of Economics and Business, Universitat Pompeu Fabra, revised Jul 1998. [Downloadable!]
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  8. Domenico Cuoco and Hua HŠ., 1994. "Dynamic Aggregation and Computation of Equilibria in Finite-Dimensional Economies with Incomplete Financial Markets," Research Program in Finance Working Papers RPF-236, University of California at Berkeley.
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    Other versions:
  13. Detemple, Jerome & Murthy, Shashidhar, 1997. "Equilibrium Asset Prices and No-Arbitrage with Portfolio Constraints," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(4), pages 1133-74.
  14. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June. [Downloadable!] (restricted)
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  15. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, vol. 46(1), pages 185-200, January. [Downloadable!] (restricted)
  16. Cuoco, Domenico, 1997. "Optimal Consumption and Equilibrium Prices with Portfolio Constraints and Stochastic Income," Journal of Economic Theory, Elsevier, vol. 72(1), pages 33-73, January. [Downloadable!] (restricted)
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