Extending the Demand System Approach to Asset Pricing

We extend the demand systems approach of Koijen and Yogo (2019) to more general classes of preferences. Specifically we analyse constant absolute and constant relative risk aversion, provide conditions for the existence of equilibrium, and evaluate equilibrium prices at US-data. We find that constant absolute risk aversion works particularly well at moderate levels of risk aversion. In the case of relative risk aversion, optimal interior portfolio solutions may not even exist. In both preference classes especially out-of-sample predictions are rather volatile. In order to improve out-of-sample performance we augment the optimal strategies by a shrinkage device. As a side product we establish that the characteristics-based parametric portfolio approach of Brandt, Santa Clara and Valkanov (2009) can only be justified as optimal investments under exceedingly strong assumptions. In empirical data the 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.