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Is Stochastic Volatility relevant for Dynamic Portfolio Choice under Ambiguity?

Author

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  • Gonçalo Faria

    () (CEF.UP and Faculdade de Economia (Universidade do Porto) and RGEA (Universidad de Vigo))

  • João Correia-da-Silva

    () (CEF.UP and Faculdade de Economia (Universidade do Porto))

Abstract

Literature on dynamic portfolio choice has been finding that volatility risk has low impact on portfolio choice. For example, using long-run U.S. data, Chacko and Viceira (2005) found that intertemporal hedging demand (required by investors for protection against adverse changes in volatility) is empirically small even for highly risk-averse investors. We want to assess if this continues to be true in the presence of ambiguity. Adopting robust control and perturbation theory techniques, we study the problem of a long-horizon investor with recursive preferences that faces ambiguity about the stochastic processes that generate the investment opportunity set. We find that ambiguity impacts portfolio choice, with the relevant channel being the return process. Ambiguity about the volatility process is only relevant if, through a specific correlation structure, it also induces ambiguity about the return process. Using the same long-run U.S. data, we find that ambiguity about the return process may be empirically relevant, much more than ambiguity about the volatility process. Anyway, intertemporal hedging demand is still very low: investors are essentially focused in the short-term risk-return characteristics of the risky asset.

Suggested Citation

  • Gonçalo Faria & João Correia-da-Silva, 2012. "Is Stochastic Volatility relevant for Dynamic Portfolio Choice under Ambiguity?," FEP Working Papers 472, Universidade do Porto, Faculdade de Economia do Porto.
  • Handle: RePEc:por:fepwps:472
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    References listed on IDEAS

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    1. Fabio Trojani & Paolo Vanini, 2004. "Robustness and Ambiguity Aversion in General Equilibrium," Review of Finance, European Finance Association, vol. 8(2), pages 279-324.
    2. Hui Chen & Nengjiu Ju & Jianjun Miao, 2014. "Dynamic Asset Allocation with Ambiguous Return Predictability," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 17(4), pages 799-823, October.
    3. Patrick Gagliardini & Paolo Porchia & Fabio Trojani, 2009. "Ambiguity Aversion and the Term Structure of Interest Rates," Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 4157-4188, October.
    4. Christian Gollier, 2011. "Portfolio Choices and Asset Prices: The Comparative Statics of Ambiguity Aversion," Review of Economic Studies, Oxford University Press, vol. 78(4), pages 1329-1344.
    5. Gonçalo Faria & João Correia-da-Silva & Cláudia Ribeiro, 2009. "Dynamic Consumption and Portfolio Choice with Ambiguity about Stochastic Volatility," FEP Working Papers 348, Universidade do Porto, Faculdade de Economia do Porto.
    6. Gonçalo Faria & João Correia-da-Silva, 2012. "The price of risk and ambiguity in an intertemporal general equilibrium model of asset prices," Annals of Finance, Springer, vol. 8(4), pages 507-531, November.
    7. Trojani, Fabio & Vanini, Paolo, 2002. "A note on robustness in Merton's model of intertemporal consumption and portfolio choice," Journal of Economic Dynamics and Control, Elsevier, vol. 26(3), pages 423-435, March.
    8. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942.
    9. David Ahn & Syngjoo Choi & Douglas Gale & Shachar Kariv, 2014. "Estimating ambiguity aversion in a portfolio choice experiment," Quantitative Economics, Econometric Society, vol. 5, pages 195-223, July.
    10. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
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    Cited by:

    1. repec:eee:dyncon:v:86:y:2018:i:c:p:49-71 is not listed on IDEAS
    2. Cristina Sacala, 2016. "Portfolio Dynamics. A Macroeconomic Model," International Journal of Academic Research in Accounting, Finance and Management Sciences, Human Resource Management Academic Research Society, International Journal of Academic Research in Accounting, Finance and Management Sciences, vol. 6(3), pages 170-176, July.

    More about this item

    Keywords

    Dynamic Portfolio Choice; Stochastic Volatility; Ambiguity; Robust Control; Perturbation Theory;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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