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Dynamic portfolio choice under ambiguity and regime switching mean returns

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  • Liu, Hening

Abstract

I examine a continuous-time intertemporal consumption and portfolio choice problem under ambiguity, where expected returns of a risky asset follow a hidden Markov chain. Investors with Chen and Epstein's (2002) recursive multiple priors utility possess a set of priors for unobservable investment opportunities. The optimal consumption and portfolio policies are explicitly characterized in terms of the Malliavin derivatives and stochastic integrals. When the model is calibrated to U.S. stock market data, I find that continuous Bayesian revisions under incomplete information generate ambiguity-driven hedging demands that mitigate intertemporal hedging demands. In addition, ambiguity aversion magnifies the importance of hedging demands in the optimal portfolio policies. Out-of-sample experiments demonstrate the economic importance of accounting for ambiguity.

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  • Liu, Hening, 2011. "Dynamic portfolio choice under ambiguity and regime switching mean returns," Journal of Economic Dynamics and Control, Elsevier, vol. 35(4), pages 623-640, April.
  • Handle: RePEc:eee:dyncon:v:35:y:2011:i:4:p:623-640
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    2. Yuki Shigeta, 2016. "Optimal Switching under Ambiguity and Its Applications in Finance," Discussion papers e-16-005, Graduate School of Economics , Kyoto University.
    3. Larsen, Linda Sandris & Munk, Claus, 2012. "The costs of suboptimal dynamic asset allocation: General results and applications to interest rate risk, stock volatility risk, and growth/value tilts," Journal of Economic Dynamics and Control, Elsevier, vol. 36(2), pages 266-293.
    4. Massimo Guidolin & Francesca Rinaldi, 2013. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Theory and Decision, Springer, vol. 74(2), pages 183-217, February.
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    8. Rubtsov, Alexey, 2016. "Model misspecification and pricing of illiquid claims," Finance Research Letters, Elsevier, vol. 18(C), pages 242-249.
    9. Wang, Haijun, 2016. "Precautionary saving demand and consumption dynamics with the spirit of capitalism and regime switching," Journal of Mathematical Economics, Elsevier, vol. 64(C), pages 48-65.
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    16. Branger, Nicole & Kraft, Holger & Meinerding, Christoph, 2014. "Partial information about contagion risk, self-exciting processes and portfolio optimization," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 18-36.
    17. Haijun Wang & L. Steven Hou, 2015. "Robust Consumption and Portfolio Choice with Habit Formation, the Spirit of Capitalism and Recursive Utility," Annals of Economics and Finance, Society for AEF, vol. 16(2), pages 393-416, November.
    18. Vladimir Dombrovskii & Tatyana Obyedko, 2014. "Dynamic Investment Portfolio Optimization under Constraints in the Financial Market with Regime Switching using Model Predictive Control," Papers 1410.1136, arXiv.org.
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