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Uncertainty Aversion, Robust Control And Asset Holdings With A Stochastic Investment Opportunity Set

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  • GIANNIS VARDAS

    () (University of Crete, Department of Economics, University Campus, Rethymno 74 100, Greece)

  • ANASTASIOS XEPAPADEAS

    () (University of Crete, Department of Economics, University Campus, Rethymno 74 100, Greece)

Abstract

We formulate the portfolio choice problem as a robust control problem under uncertainty or ambiguity aversion. By considering a stochastic investment opportunity set, we derive optimal robust portfolio rules in the cases of one and two risky assets. With two risky assets and ambiguity structure determined by economy-wide factors, we show that the robust portfolio rule could lead to an increase in the total holdings of risky assets as compared to the holdings under the Merton rule, which is the standard risk aversion case. This result goes against the general belief that uncertainty aversion and robust control methods lead to conservative behavior. We also show that the investor is more likely to increase the holdings of the asset for which there is no ambiguity, and reduce the holdings of the asset for which there is ambiguity, a result that might provide an explanation for the home bias puzzle.

Suggested Citation

  • Giannis Vardas & Anastasios Xepapadeas, 2007. "Uncertainty Aversion, Robust Control And Asset Holdings With A Stochastic Investment Opportunity Set," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(06), pages 985-1014.
  • Handle: RePEc:wsi:ijtafx:v:10:y:2007:i:06:n:s0219024907004524
    DOI: 10.1142/S0219024907004524
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    References listed on IDEAS

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    1. Alexei Onatski & Noah Williams, 2003. "Modeling Model Uncertainty," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1087-1122, September.
    2. William A. Brock & Steven N. Durlauf, 2004. "Elements of a Theory of Design Limits to Optimal Policy," Manchester School, University of Manchester, vol. 72(s1), pages 1-18, September.
    3. William A. Brock & Steven N. Durlauf & Kenneth D. West, 2003. "Policy Evaluation in Uncertain Economic Environments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 235-322.
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