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Asset allocation: How much does model choice matter?

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  • Branger, Nicole
  • Hansis, Alexandra

Abstract

This paper analyzes the optimal portfolio decision of a CRRA investor in models with stochastic volatility and stochastic jumps. The investor follows a buy-and-hold strategy in the stock, the money market account, and one additional derivative. We show that both the type of the model and the structure of the risk premia have a significant impact on the optimal portfolio, on the utility gain from having access to derivatives, and on whether the investor prefers to trade OTM or ATM options. We also show that model mis-specification results in significant utility losses. Omitting jumps in volatility can be devastating, in particular if the investor chooses the seemingly optimal OTM put options. A misestimation of the structure of the risk premia has a less devastating effect, but can still lead to a loss of around 4% in the annual certainty equivalent return.

Suggested Citation

  • Branger, Nicole & Hansis, Alexandra, 2012. "Asset allocation: How much does model choice matter?," Journal of Banking & Finance, Elsevier, vol. 36(7), pages 1865-1882.
  • Handle: RePEc:eee:jbfina:v:36:y:2012:i:7:p:1865-1882
    DOI: 10.1016/j.jbankfin.2012.02.009
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    References listed on IDEAS

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    Cited by:

    1. repec:eee:dyncon:v:85:y:2017:i:c:p:59-89 is not listed on IDEAS
    2. Horváth, Ferenc, 2017. "Essays on robust asset pricing," Other publications TiSEM e54d7b33-1f27-4b0e-9f84-f, Tilburg University, School of Economics and Management.
    3. Branger, Nicole & Hansis, Alexandra, 2015. "Earning the right premium on the right factor in portfolio planning," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 367-383.

    More about this item

    Keywords

    Stochastic volatility; Jumps; Market prices of risk; Asset allocation; Buy-and-hold strategy; Model mis-specification;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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