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

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