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Dynamic Consumption and Portfolio Choice with Ambiguity about Stochastic Volatility

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Author Info

  • Gonçalo Faria

    ()
    (Faculdade de Economia, Universidade do Porto)

  • João Correia-da-Silva

    ()
    (CEF.UP, Faculdade de Economia, Universidade do Porto)

  • Cláudia Ribeiro

    ()
    (CEF.UP, Faculdade de Economia, Universidade do Porto)

Abstract

We introduce ambiguity about the variance of the risky asset's return in the model of Chacko and Viceira (2005) for dynamic consumption and portfolio choice with stochastic variance. We find that, with investors being able to update their portfolio continuously (as a function of the instantaneous variance), ambiguity has no impact. To shed some light on the case in which continuous portfolio updating is not possible, we also evaluate the effect of ambiguity when investors must use their expectation of future variance for their portfolio decision. In the latter scenario, demand for the risky asset can be decomposed into three components: myopic and intertemporal hedging demands (as in Chacko and Viceira (2005)) and ambiguity demand. Using long-run US data, Chacko and Viceira (2005) found that intertemporal hedging demand is empirically small, suggesting a low impact of stochastic variance on portfolio choice. Using the same calibration, we find that ambiguity demand may be very high, much more than intertemporal hedging demand. Therefore, stochastic variance can be very relevant for portfolio choice, not because of the variance risk, but because of investors' ambiguity about variance.

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File URL: http://www.fep.up.pt/investigacao/workingpapers/09.12.09_wp348.pdf
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Bibliographic Info

Paper provided by Universidade do Porto, Faculdade de Economia do Porto in its series FEP Working Papers with number 348.

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Length: 37 pages
Date of creation: Dec 2009
Date of revision:
Handle: RePEc:por:fepwps:348

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Keywords: Asset Allocation; Stochastic Volatility; Ambiguity;

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Cited by:
  1. Gonçalo Faria & João Correia-da-Silva, 2012. "Is Stochastic Volatility relevant for Dynamic Portfolio Choice under Ambiguity?," FEP Working Papers 472, Universidade do Porto, Faculdade de Economia do Porto.
  2. Massimo Guidolin & Francesca Rinaldi, 2010. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Working Papers 2010-028, Federal Reserve Bank of St. Louis.

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