Consumption and Portfolio Decisions When Expected Returns are Time Varying

74 Pages Posted: 1 Aug 2000 Last revised: 4 Oct 2010

See all articles by John Y. Campbell

John Y. Campbell

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

Luis M. Viceira

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Date Written: December 1996

Abstract

This paper proposes and implements a new approach to a classic unsolved problem in financial economics: the optimal consumption and portfolio choice problem of a long-lived investor facing time-varying investment opportunities. The investor is assumed to be infinitely-lived, to have recursive Epstein-Zin-Weil utility, and to choose in discrete time between a riskless asset with a constant return, and a risky asset with constant return variance whose expected log return follows and AR(1) process. The paper approximates the choice problem by log-linearizing the budget constraint and Euler equations, and derives an analytical solution to the approximate problem. When the model is calibrated to US stock market data it implies that intertemporal hedging motives greatly increase, and may even double, the average demand for stocks by investors whose risk-aversion coefficients exceed one.

Suggested Citation

Campbell, John Y. and Viceira, Luis M., Consumption and Portfolio Decisions When Expected Returns are Time Varying (December 1996). NBER Working Paper No. w5857. Available at SSRN: https://ssrn.com/abstract=225642

John Y. Campbell (Contact Author)

Harvard University - Department of Economics ( email )

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Luis M. Viceira

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
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617-496-6592 (Fax)

HOME PAGE: http://www.people.hbs.edu/lviceira

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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