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Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies

Leonid Kogan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Raman Uppal

EDHEC Business School;

July 2000

EFA 0278

In this article, we examine analytically the optimal consumption and portfolio policies in an economy with incomplete financial markets where agents have power utility over intermediate consumption and bequest, and face portfolio constraints and a stochastic investment opportunity set. The source of changes in the investment opportunity set could be a stochastic instantaneous interest rate, stochastic volatility, and/or a stochastic risk premium. We find analytically the conditions under which investment in the risky asset can increase with risk aversion. We then nest this portfolio problem in a general equilibrium setting (for a production economy and also for an exchange economy) with multiple agents who differ in their degree of risk aversion. We derive the optimal portfolio policies when the evolution of the investment opportunity set is determined endogenously and also characterize explicitly the interest rate, stock price and risk premium in general equilibrium. The exact local comparative statics and approximate but analytical expressions for the optimal policies are obtained by developing a method based on perturbation analysis to expand around the solution for an investor with log utility.

Number of Pages in PDF File: 63

Keywords: Asset allocation, stochastic investment opportunities, incomplete markets, borrowing constraints, asymptotic analysis

JEL Classification: G12, G11, D52, C63

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Date posted: August 24, 2000  

Suggested Citation

Kogan, Leonid and Uppal , Raman, Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies (July 2000). EFA 0278. Available at SSRN: http://ssrn.com/abstract=236041 or http://dx.doi.org/10.2139/ssrn.236041

Contact Information

Leonid Kogan (Contact Author)
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
50 Memorial Drive
Cambridge, MA 02142
United States
617-253-2289 (Phone)
617-258-6855 (Fax)
HOME PAGE: http://web.mit.edu/lkogan2/www/
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Raman Uppal
EDHEC Business School ( email )
58 rue du Port
Lille, 59046
90-98 Goswell Road
London, EC1V 7RR
United Kingdom
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