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Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies

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  • Leonid Kogan
  • Raman Uppal

Abstract

In this article, we show how to analyze analytically the equilibrium policies and prices in an economy with a stochastic investment opportunity set and incomplete financial markets, when agents have power utility over both intermediate consumption and terminal wealth, and face portfolio constraints. The exact local comparative statics and approximate but analytical expression for the portfolio policy and asset prices are obtained by developing a method based on perturbation analysis to expand around the solution for an investor with log utility. We then use this method to study a general equilibrium exchange economy with multiple agents who differ in their degree of risk aversion and face borrowing constraints. We characterize explicitly the consumption and portfolio policies and also the properties of asset returns. We find that the volatility of stock returns increases with the cross-sectional dispersion of risk aversion, with the cross-sectional dispersion in portfolio holdings, and with the relaxation of the constraint on borrowing. Moreover, tightening the borrowing constraint lowers the risk-free interest rate and raises the equity premium in equilibrium.
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  • Leonid Kogan & Raman Uppal, "undated". "Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies," Rodney L. White Center for Financial Research Working Papers 13-00, Wharton School Rodney L. White Center for Financial Research.
  • Handle: RePEc:fth:pennfi:13-00
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    File URL: http://finance.wharton.upenn.edu/%7Erlwctr/papers/0012.pdf
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    References listed on IDEAS

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    Cited by:

    1. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
    2. Weinbaum, David, 2010. "Preference heterogeneity and asset prices: An exact solution," Journal of Banking & Finance, Elsevier, vol. 34(9), pages 2238-2246, September.
    3. Sanjiv Ranjan Das & Raman Uppal, 2004. "Systemic Risk and International Portfolio Choice," Journal of Finance, American Finance Association, vol. 59(6), pages 2809-2834, December.
    4. Pavlova, Anna & Rigobon, Roberto, 2010. "An asset-pricing view of external adjustment," Journal of International Economics, Elsevier, vol. 80(1), pages 144-156, January.
    5. Farhi, Emmanuel & Panageas, Stavros, 2007. "Saving and investing for early retirement: A theoretical analysis," Journal of Financial Economics, Elsevier, vol. 83(1), pages 87-121, January.
    6. Najafi, Amir Abbas & Pourahmadi, Zahra, 2016. "An efficient heuristic method for dynamic portfolio selection problem under transaction costs and uncertain conditions," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 448(C), pages 154-162.
    7. Mele, Antonio, 2004. "General Properties of Rational Stock-Market Fluctuations," Economics Series 153, Institute for Advanced Studies.
    8. Judd, Kenneth L. & Leisen, Dietmar P.J., 2010. "Equilibrium open interest," Journal of Economic Dynamics and Control, Elsevier, vol. 34(12), pages 2578-2600, December.
    9. Gollier Christian, 2004. "Optimal Dynamic Portfolio Risk with First-Order and Second-Order Predictability," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 4(1), pages 1-35, September.
    10. Kasper Larsen & Oleksii Mostovyi & Gordan v{Z}itkovi'c, 2014. "An expansion in the model space in the context of utility maximization," Papers 1410.0946, arXiv.org, revised Aug 2016.
    11. Leippold, Markus & Trojani, Fabio & Vanini, Paolo, 2006. "Equilibrium impact of value-at-risk regulation," Journal of Economic Dynamics and Control, Elsevier, vol. 30(8), pages 1277-1313, August.
    12. Bhamra, Harjoat S. & Coeurdacier, Nicolas & Guibaud, Stéphane, 2014. "A dynamic equilibrium model of imperfectly integrated financial markets," Journal of Economic Theory, Elsevier, vol. 154(C), pages 490-542.
    13. Michael W. Brandt & Amit Goyal & Pedro Santa-Clara & Jonathan R. Stroud, 2005. "A Simulation Approach to Dynamic Portfolio Choice with an Application to Learning About Return Predictability," Review of Financial Studies, Society for Financial Studies, vol. 18(3), pages 831-873.
    14. Marco Bonomo & René Garcia & Nour Meddahi & Roméo Tédongap, 2011. "Generalized Disappointment Aversion, Long-run Volatility Risk, and Asset Prices," Review of Financial Studies, Society for Financial Studies, vol. 24(1), pages 82-122.
    15. Mao-Wei Hung & Hsiao-Yuan Yu, 2006. "A heterogeneous model of disposition effect," Applied Economics, Taylor & Francis Journals, vol. 38(18), pages 2147-2157.
    16. Paolo Porchia & Pedro Gete, 2011. "Fertility and Consumption when Having a Child is a Risky Investment," 2011 Meeting Papers 563, Society for Economic Dynamics.
    17. Martin D. D. Evans & Viktoria Hnatkovska, 2005. "Solving General Equilibrium Models with Incomplete Markets and Many Assets," NBER Technical Working Papers 0318, National Bureau of Economic Research, Inc.
    18. Harjoat S. Bhamra & Raman Uppal, 2014. "Asset Prices with Heterogeneity in Preferences and Beliefs," Review of Financial Studies, Society for Financial Studies, vol. 27(2), pages 519-580.
    19. Gollier, Christian, 2005. "Optimal Portfolio Management for Individual Pension Plans," IDEI Working Papers 298, Institut d'Économie Industrielle (IDEI), Toulouse.
    20. Mao-Wei Hung & Mei-Lan Lo & Hsiao-Yuan Yu, 2010. "On the currency effect to home bias puzzle," Applied Economics Letters, Taylor & Francis Journals, vol. 17(8), pages 815-822.
    21. Björn Bick & Holger Kraft & Claus Munk, 2013. "Solving Constrained Consumption-Investment Problems by Simulation of Artificial Market Strategies," Management Science, INFORMS, vol. 59(2), pages 485-503, June.
    22. Ludvigson, Sydney C., 2013. "Advances in Consumption-Based Asset Pricing: Empirical Tests," Handbook of the Economics of Finance, Elsevier.
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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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