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Extending the demand system approach to asset pricing

Author

Listed:
  • Thomas Gehrig

    (University of Vienna
    Vienna Graduate School of Finance (VGSF))

  • Leopold Sögner

    (Institute for Advanced Studies
    Vienna Graduate School of Finance (VGSF))

  • Arne Westerkamp

    (IQAM Invest GmbH)

Abstract

This article introduces a shrinkage procedure which allows to improve upon the parametric portfolio approach introduced in Brandt et al (Review of Financial Studies 22(9): 3411–3477, 2009) and more general factor conditional frameworks. We analyze optimal investment decisions for constant absolute and constant relative risk aversion. In both preference classes, especially out-of-sample performance of the optimal strategies is rather volatile. In order to reduce parameter and model uncertainty, we augment the optimal strategies by a shrinkage device that pulls the portfolio weights toward a predetermined policy portfolio. Our theoretical approach thereby extends the demand systems approach of Koijen and Yogo (Journal of Political Economy, 127(4):1475–1515, 2019) to more general classes of preferences and provides conditions for the existence of equilibrium. As a side product, we establish that the characteristics-based parametric portfolio approach of Brandt et al. (Review of Financial Studies 22(9): 3411–3477, 2009) can only be justified as optimal investments under exceedingly strong assumptions. In empirical US data, our shrinkage approach outperforms the parametric approach and the naive 1/N-strategy over quite a wide range of levels of absolute and relative risk aversion.

Suggested Citation

  • Thomas Gehrig & Leopold Sögner & Arne Westerkamp, 2025. "Extending the demand system approach to asset pricing," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 39(1), pages 133-166, March.
  • Handle: RePEc:kap:fmktpm:v:39:y:2025:i:1:d:10.1007_s11408-024-00463-4
    DOI: 10.1007/s11408-024-00463-4
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    More about this item

    Keywords

    Parametric portfolio policy; Expected utility; Risk aversion;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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