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Is the Volatility of the Market Price of Risk Due to Intermittent Portfolio Re-Balancing?

66 Pages Posted: 18 Feb 2010 Last revised: 15 Jul 2014

YiLi Chien

Federal Reserve Banks - Federal Reserve Bank of St. Louis

Harold L. Cole

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: April 23, 2010

Abstract

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.

Keywords: Portfolio Rebalancing

JEL Classification: G12

Suggested Citation

Chien, YiLi and Cole, Harold L. and Lustig, Hanno N., Is the Volatility of the Market Price of Risk Due to Intermittent Portfolio Re-Balancing? (April 23, 2010). American Economic Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1554741 or http://dx.doi.org/10.2139/ssrn.1554741

YiLi Chien

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

411 Locust St
Saint Louis, MO 63011
United States

Harold L. Cole

University of Pennsylvania - Department of Economics ( email )

3718 Locust Walk
436 McNeil
Philadelphia, PA 19104
United States
215-898-7788 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Hanno N. Lustig (Contact Author)

Stanford Graduate School of Business ( email )

Stanford GSB
655 Knight Way
Stanford, CA California 94305-6072
United States
3108716532 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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