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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 and 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 investors whose risk-aversion coefficients exceed one.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5857.

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Date of creation: Dec 1996
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Publication status: published as The Quarterly Journal of Economics, Vol. CXIV (May 1999), Issue 2: 433-496.
Handle: RePEc:nbr:nberwo:5857

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  1. John Y. CAMPBELL & Luis VICEIRA, 1998. "Who Should Buy Long-Term Bonds?," FAME Research Paper Series rp5, International Center for Financial Asset Management and Engineering.
  2. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  3. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
  4. John Y. Campbell & Luis M. Viceira, 1996. "Consumption and Portfolio Decisions When Expected Returns are Time Varying," NBER Working Papers 5857, National Bureau of Economic Research, Inc.
  5. 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.
  6. 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.
  7. 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.
  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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