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Is the Volatility of the Market Price of Risk due to Intermittent Portfolio Re-balancing?

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  • Yi-Li Chien
  • Harold L. Cole
  • Hanno Lustig

Abstract

Our paper examines whether the well-documented failure of unsophisticated investors to rebalance their portfolios can help to explain the enormous counter-cyclical volatility of aggregate risk compensation in financial markets. To answer this question, we set up a model in which CRRA-utility investors have heterogeneous trading technologies. In our model, a large mass of investors do not re-balance their portfolio shares in response to aggregate shocks, while a smaller mass of active investors adjust their portfolio each period to respond to changes in the investment opportunity set. We find that these intermittent re-balancers more than double the effect of aggregate shocks on the time variation in risk premia by forcing active traders to sell more shares in good times and buy more shares in bad times.

Suggested Citation

  • Yi-Li Chien & Harold L. Cole & Hanno Lustig, 2009. "Is the Volatility of the Market Price of Risk due to Intermittent Portfolio Re-balancing?," NBER Working Papers 15382, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:15382
    Note: AP EFG
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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