Asset Allocation: How Much Does Model Choice Matter?

46 Pages Posted: 18 Mar 2009 Last revised: 3 Feb 2010

See all articles by Nicole Branger

Nicole Branger

University of Muenster - Finance Center Muenster

Alexandra Hansis

Goethe University Frankfurt - House of Finance

Date Written: February 1, 2010

Abstract

This paper analyzes the optimal portfolio decision of a CRRA investor in models with stochastic volatility and stochastic jumps. The investor has access to one additional derivative, besides the stock and the money market account, but is restricted to a buy-and-hold strategy. We find that the structure of the risk premia has a significant impact on the optimal portfolio decision as well as on the utility gain due to having access to derivatives. This structure is of equal importance as the choice of the model. The model as well as the risk premia also have an impact on whether the investor prefers to trade OTM or ATM options. The dependence of the optimal portfolio on the specific model and on the specific assumptions on the risk premia leads to significant utility losses in case of model misspecification. So can the results of omitting jumps in the volatility be devastating, in particular if the investor chooses the seemingly optimal OTM put options. A misestimation of the structure of the risk premia has less devastating effect, but can still lead to a loss of around 5% in certainty equivalent return.

Keywords: stochastic volatility, jumps, market prices of risk, asset allocation, buy-and-hold strategy, model mis-specification

JEL Classification: G11

Suggested Citation

Branger, Nicole and Hansis, Alexandra, Asset Allocation: How Much Does Model Choice Matter? (February 1, 2010). Available at SSRN: https://ssrn.com/abstract=1362066 or http://dx.doi.org/10.2139/ssrn.1362066

Nicole Branger (Contact Author)

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Alexandra Hansis

Goethe University Frankfurt - House of Finance ( email )

Campus Westend, Grueneburgplatz 1
Uni-Postfach H 13
Frankfurt, 60323
Germany

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