Portfolio and Consumption Decisions Under Mean-Reverting Returns: An Exact Solution for Complete Markets

36 Pages Posted: 26 Nov 2001

See all articles by Jessica A. Wachter

Jessica A. Wachter

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

Multiple version iconThere are 2 versions of this paper

Date Written: November 19, 2001

Abstract

This paper solves, in closed form, the optimal portfolio choice problem for an investor with utility over consumption under mean-reverting returns. Previous solutions either require approximations, numerical methods, or the assumption that the investor does not consume over his lifetime. This paper breaks the impasse by assuming that markets are complete. The solution leads to a new understanding of hedging demand and of the behavior of the approximate log-linear solution. The portfolio allocation takes the form of a weighted average and is shown to be analogous to duration for coupon bonds. Through this analogy, the notion of investment horizon is extended to that of an investor who consumes at multiple points in time.

Suggested Citation

Wachter, Jessica A., Portfolio and Consumption Decisions Under Mean-Reverting Returns: An Exact Solution for Complete Markets (November 19, 2001). Available at SSRN: https://ssrn.com/abstract=291472 or http://dx.doi.org/10.2139/ssrn.291472

Jessica A. Wachter (Contact Author)

University of Pennsylvania - Finance Department ( email )

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