Wealth Effect on Portfolio Allocation in Incomplete Markets

71 Pages Posted: 22 Apr 2020 Last revised: 30 Aug 2021

See all articles by Chenxu Li

Chenxu Li

Peking University - Guanghua School of Management

O. Scaillet

University of Geneva GSEM and GFRI; Swiss Finance Institute; University of Geneva - Research Center for Statistics

Yiwen Shen

Hong Kong University of Science & Technology (HKUST) - Department of Information Systems, Business Statistics and Operations Management

Date Written: April 20, 2020

Abstract

We develop a novel five-component decomposition of optimal dynamic portfolio choice, which reveals the simultaneous impacts from market incompleteness and wealth-dependent utilities. Under the HARA utility and a nonrandom interest rate, we can explicitly solve for the optimal policy as a combination of a bond holding scheme and the corresponding simpler CRRA strategy. Under a stochastic volatility model estimated on US equity data, we use closed-form solution to demonstrate the sophisticated impacts from the wealth-dependent utilities, including cycle-dependence and hysteresis effect in optimal portfolio allocation, as well as a risk-return trade-off in investment performance.

Keywords: optimal portfolio choice, stochastic volatility, incomplete market, wealth-dependent utility, closed-form

JEL Classification: C61, C63, G11

Suggested Citation

Li, Chenxu and Scaillet, Olivier and Shen, Yiwen, Wealth Effect on Portfolio Allocation in Incomplete Markets (April 20, 2020). Swiss Finance Institute Research Paper No. 20-22, Available at SSRN: https://ssrn.com/abstract=3580735 or http://dx.doi.org/10.2139/ssrn.3580735

Chenxu Li

Peking University - Guanghua School of Management ( email )

Guanghua School of Management
Beijing, 100871
China

Olivier Scaillet (Contact Author)

University of Geneva GSEM and GFRI ( email )

40 Boulevard du Pont d'Arve
Geneva 4, Geneva 1211
Switzerland
+ 41 22 379 88 16 (Phone)
+41 22 389 81 04 (Fax)

HOME PAGE: http://www.scaillet.ch

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva - Research Center for Statistics

Geneva
Switzerland

Yiwen Shen

Hong Kong University of Science & Technology (HKUST) - Department of Information Systems, Business Statistics and Operations Management ( email )

Clear Water Bay
Kowloon
Hong Kong

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