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Consumption and Portfolio Decisions When Expected Returns Are Time Varying

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  • John Y. Campbell
  • Luis M. Viceira

Abstract

This paper proposes and implements a new approach to a classic unsolved problem in financial economics: the optimal consumption and portfolio choice problem of a long-lived investor facing time-varying investment opportunities. The investor is assumed to be infinitely lived, to have recursive Epstein-Zin-Weil utility, and to choose in discrete time between a riskless asset with a constant return, and a risky asset with constant return variance whose expected log return follows an AR(1) process. The paper approximates the choice problem by log-linearizing the budget constraint and Euler equations, and derives an analytical solution to the approximate problem. When the model is calibrated to US stock market data it implies that intertemporal hedging motives greatly increase, and may even double, the average demand for stocks by long-lived investors whose risk-aversion coefficients exceed one. The optimal portfolio policy also involves timing the stock market. Failure to time or to hedge can cause large welfare losses relative to the optimal policy.

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Bibliographic Info

Paper provided by Harvard - Institute of Economic Research in its series Harvard Institute of Economic Research Working Papers with number 1835.

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Date of creation: 1998
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Handle: RePEc:fth:harver:1835

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  1. Viceira, Luis & Campbell, John, 1999. "Consumption and Portfolio Decisions When Expected Returns are Time Varying," Scholarly Articles 3163266, Harvard University Department of Economics.
  2. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  3. John Y. Campbell & Luis M. Viceira, 1998. "Who Should Buy Long-Term Bonds?," NBER Working Papers 6801, National Bureau of Economic Research, Inc.
  4. Alberto Giovannini & Philippe Weil, 1989. "Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model," NBER Working Papers 2824, National Bureau of Economic Research, Inc.
  5. Campbell, John Y., 1987. "Stock returns and the term structure," Journal of Financial Economics, Elsevier, vol. 18(2), pages 373-399, June.
  6. Brennan, Michael J. & Schwartz, Eduardo S. & Lagnado, Ronald, 1997. "Strategic asset allocation," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1377-1403, June.
  7. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
  8. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
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