Is the Volatility of the Market Price of Risk Due to Intermittent Portfolio Re-Balancing?
Federal Reserve Bank of St. Louis
Harold L. Cole
University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)
Hanno N. Lustig
UCLA - Anderson School of Management; National Bureau of Economic Research (NBER)
April 23, 2010
American Economic Review, Forthcoming
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 amplify the effect of aggregate shocks on the time variation in risk premia by a factor of three by forcing active traders to sell more shares in good times and buy more shares in bad times.
Number of Pages in PDF File: 66
Keywords: Portfolio Rebalancing
JEL Classification: G12Accepted Paper Series
Date posted: February 18, 2010 ; Last revised: August 24, 2012
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