Correlation Risk and Optimal Portfolio Choice
The University of Chicago; Imperial College Business School; Centre for Economic Policy Research (CEPR)
IE Business School
Swiss Finance Institute; University of Lugano
May 26, 2006
AFA 2008 New Orleans Meetings Paper
We develop a new framework for intertemporal portfolio choice when the covariance matrix of returns is stochastic. An important contribution of this framework is that it allows to derive optimal portfolio implications for economies in which the degree of correlation across different industries, countries, and asset classes is time-varying and stochastic. In this setting, markets are incomplete and optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk. The model gives rise to simple optimal portfolio solutions that are available in closed-form. We use these solutions to investigate, in several concrete applications, the properties of the optimal portfolios. We find that the hedging demand is typically four to five times larger than in univariate models and it includes an economically significant correlation hedging component, which tends to increase with the persistence of variance covariance shocks, the strength of leverage effects and the dimension of the investment opportunity set. These findings persist also in the discrete-time portfolio problem with short-selling or VaR constraints.
Number of Pages in PDF File: 58
Keywords: Dynamic Porfolio Choice, Stochastic Correlation, Intertemporal Hedging
JEL Classification: G11, G13
Date posted: June 14, 2006 ; Last revised: February 16, 2009
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