How Important is Intertemporal Risk for Asset Allocation?

48 Pages Posted: 23 Jul 2003

See all articles by Guojun Wu

Guojun Wu

University of Houston; China Academy of Financial Research (CAFR)

Bruno Gerard

BI Norwegian Business School - Department of Finance

Date Written: June 9, 2003

Abstract

How important is Merton's intertemporal risk for asset allocation decisions? To address this question we jointly estimate and test a conditional asset pricing model which includes long term interest rate risk as a potentially priced factor for four broad classes of assets - large stocks, small stocks, long term Treasury bonds and corporate bonds. We find that the premium for long bond risk is the main component of the risk premiums of Treasury bond and corporate bond portfolios, while it represents a small fraction of total risk premiums for equities. Our results suggest that investors perceive stocks and especially small stocks as hedges against variations in the investment opportunity set. Since these four asset classes represent some of the most important for investors, we proceed to use our estimates to compute the optimal asset allocations for investors who optimize with or without taking into account the intertemporal risk. We provide a set of measures to investigate the importance of this risk. We find that at average market volatility levels, investors can earn annual premiums between 3.6% during expansions and 5.8% during recessions for bearing intertemporal risk alone. These results underscore the importance of explicitly considering intertemporal risk in asset allocation decisions, especially during down markets and business recessions.

Suggested Citation

Wu, Guojun and Gerard, Bruno, How Important is Intertemporal Risk for Asset Allocation? (June 9, 2003). EFA 2003 Annual Conference Paper No. 220. Available at SSRN: https://ssrn.com/abstract=424325 or http://dx.doi.org/10.2139/ssrn.424325

Guojun Wu

University of Houston ( email )

220F Melcher Hall
Houston, TX 77204-6021
United States
713-743-4813 (Phone)
713-743-4789 (Fax)

HOME PAGE: http://www.bauer.uh.edu/wu

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

Bruno Gerard (Contact Author)

BI Norwegian Business School - Department of Finance ( email )

Nydalsveien 37
Oslo, N-0484
Norway
+4746410506 (Phone)

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