Asset Allocation: How Much Does Model Choice Matter?
46 Pages Posted: 18 Mar 2009 Last revised: 3 Feb 2010
Date Written: February 1, 2010
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: Suggested Citation