Is the Volatility of the Market Price of Risk Due to Intermittent Portfolio Re-Balancing?

Abstract:     
Our paper examines whether intermittent portfolio re-balancing on the part of some stock market investors can help to explain the counter-cyclical volatility of aggregate risk compensation in financial markets. To answer this question, we set up an incomplete markets model in which CRRA-utility investors are subject to aggregate and idiosyncratic shocks and have heterogeneous trading technologies. In our model, a large mass of passive 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 intermittent re-balancers, compared to continuous re-balancers, amplify the countercyclical volatility of risk premia by a factor of four in a calibrated version of our model.

Keywords: Asset Pricing, Household Finance, Risk Sharing, Limited Participation

JEL Classifications: G12

Working Paper Series