Consumption and Portfolio Decisions When Expected Returns Are Time Varying
This paper proposes and implements a new approach to a classic unsolved problem in financial economics: the optimal consumption and portfolio choice problem of a long-lived investor facing time-varying investment opportunities. The investor is assumed to be infinitely lived, to have recursive Epstein-Zin-Weil utility, and to choose in discrete time between a riskless asset with a constant return, and a risky asset with constant return variance whose expected log return follows an AR(1) process. The paper approximates the choice problem by log-linearizing the budget constraint and Euler equations, and derives an analytical solution to the approximate problem. When the model is calibrated to US stock market data it implies that intertemporal hedging motives greatly increase, and may even double, the average demand for stocks by long-lived investors whose risk-aversion coefficients exceed one. The optimal portfolio policy also involves timing the stock market. Failure to time or to hedge can cause large welfare losses relative to the optimal policy.
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|Date of creation:||1998|
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Web page: http://www.economics.harvard.edu/journals/hier
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- Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
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