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Stratetic Asset Allocation with an Arbitrage-Free Bond Market using Dynamic Programming

Author

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  • Carl Chiarella
  • Chih-ying Hsiao

Abstract

Recently, Campbell and Viceira (2002) have introduced a framework that allows for dynamic decisions in asset allocation. This paper follows up their work by showing how uncertainties and expectations may affect consumption and portfolio decisions in an intertemporal dynamic framework. We use the framework laid out by Merton(1973) for this type of model. We integrate into Merton's framework multi-factor models of bond pricing that satisfy the No-Arbitrage Principle. However, in this situation the intertemporal dynamic consumption and portfolio decision cannot be studied analytically by the integration of the multi-factors bond models as in Merton's original approach. In this paper the intertemporal optimization problem will be solved numerically using the method of the Dynamic Programming will be employed. The numerical errors due to the discretization of time and state space will be examined. Various properties of the optimal solution will be demonstrated numerically.

Suggested Citation

  • Carl Chiarella & Chih-ying Hsiao, 2004. "Stratetic Asset Allocation with an Arbitrage-Free Bond Market using Dynamic Programming," Computing in Economics and Finance 2004 73, Society for Computational Economics.
    • Handle: RePEc:sce:scecf4:73
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    Cited by:

    1. Willi Semmler, 2011. "Asset Prices, Booms and Recessions," Springer Books, Springer, number 978-3-642-20680-1, June.

    More about this item

    Keywords

    Merton's intertemporal model; numerical dynamic programming;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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