Consumption and Portfolio Choice with Option-Implied State Prices

47 Pages Posted: 26 Feb 2008

See all articles by Yacine Ait-Sahalia

Yacine Ait-Sahalia

Princeton University - Department of Economics

Michael W. Brandt

Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER)

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Date Written: February 24, 2008

Abstract

We propose an empirical implementation of the consumption-investment problem using the martingale representation alternative to dynamic programming. Our method is based on the direct observation of state prices from options data. This greatly simplifies the investor's task of specifying the investment opportunity set and inherits the computational convenience of the martingale representation. Our method also makes explicit the economic trade-off between exploiting differences in state prices and probabilities, which generate variation in consumption, and the consumption smoothing induced by risk aversion. Using options-implied information, we find quantitatively different optimal consumption and portfolio policies than those implied by standard return dynamics.

Keywords: Portfolio problem, martingale representation

JEL Classification: G11, G13

Suggested Citation

Ait-Sahalia, Yacine and Brandt, Michael W., Consumption and Portfolio Choice with Option-Implied State Prices (February 24, 2008). AFA 2009 San Francisco Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1097409 or http://dx.doi.org/10.2139/ssrn.1097409

Yacine Ait-Sahalia (Contact Author)

Princeton University - Department of Economics ( email )

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Michael W. Brandt

Duke University - Fuqua School of Business ( email )

1 Towerview Drive
Durham, NC 27708-0120
United States

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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