Limited Commitment, Business Cycle, and Portfolio Selection

49 Pages Posted: 6 Feb 2015 Last revised: 13 Aug 2019

See all articles by Kyoung Jin Choi

Kyoung Jin Choi

University of Calgary - Haskayne School of Business

Hyeng Keun Koo

Ajou University - Department of Business Administration

Byung Hwa Lim

The University of Suwon - Department of Economics and Finance

Jane Yoo

Ajou University - School of Business

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Date Written: August 12, 2019

Abstract

We study a continuous-time model of consumption and portfolio selection with limited commitment in a stochastic environment. The credit constraints of a household are determined endogenously in the credit market where creditors know that the household is not committed to payment of debt. By using a duality approach, we transform the problem into a dual minimization problem and subsequently into optimal stopping problems. We derive the time-varying endogenous credit limit and optimal consumption and investment strategies in closed form. We show that the credit limit is cyclical: it is lower (higher) when the Sharpe ratio of the risky asset is high (low). We find that a change in the credit limit and the counter-cyclical Sharpe ratio generate a heterogeneous investment pattern: the rich tend to increase the proportion of risky investment in downturns whereas the poor decrease it, a finding supported by the Survey of Consumer Finance data.

Keywords: Consumption and Investment; Portfolio Selection; Endogenous Credit; Regime Switch; Unsecured Borrowing

JEL Classification: C73, D11, D15, G11

Suggested Citation

Choi, Kyoung Jin and Koo, Hyeng Keun and Lim, Byung Hwa and Yoo, Jane, Limited Commitment, Business Cycle, and Portfolio Selection (August 12, 2019). Available at SSRN: https://ssrn.com/abstract=2560607 or http://dx.doi.org/10.2139/ssrn.2560607

Kyoung Jin Choi

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

HOME PAGE: http://sites.google.com/site/kyoungjinchoiecon/

Hyeng Keun Koo

Ajou University - Department of Business Administration ( email )

206 Worldcup-ro
Yeongtong-gu
Suwon, 443-749
Korea, Republic of (South Korea)

Byung Hwa Lim

The University of Suwon - Department of Economics and Finance ( email )

17 Wauan-gil
Bongdam-eup
Hwaseong, Gyeonggi-do 445-743
+82-10-5007-4310 (Phone)

HOME PAGE: http://https://sites.google.com/site/byunghwalim/

Jane Yoo (Contact Author)

Ajou University - School of Business ( email )

206 Worldcup-ro
Yeongtong-gu
Suwon
Korea, Republic of (South Korea)

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