Dynamic Asset Allocation with Stochastic Income and Interest Rates

63 Pages Posted: 2 Mar 2005 Last revised: 5 Aug 2009

See all articles by Claus Munk

Claus Munk

Copenhagen Business School

Carsten Sørensen

Copenhagen Business School - Department of Finance

Date Written: March 26, 2009

Abstract

We investigate the optimal investment and consumption choice of individual investors with uncertain future labor income operating in a financial market with stochastic interest rates. Since the present value of the individual's future income is a main determinant of the optimal behavior and this present value depends heavily on the interest rate dynamics, the joint stochastics of income and interest rates will have consequences beyond the separate effects of stochastic income and stochastic interest rates. We study both the case where income risk is spanned and there are no portfolio constraints and the case with non-spanned income risk and a constraint ruling out borrowing against future income. For the spanned, unconstrained problem we study a special case in which we obtain closed-form expressions for the optimal policies. For the unspanned, constrained problem we implement a numerical solution technique and compare the solutions to the spanned, unconstrained problem. We also allow for typical life-cycle variations in labor income.

Keywords: Portfolio management, labor income risk, interest rate risk, hedging, borrowing constraints, life-cycle

JEL Classification: G11, E21

Suggested Citation

Munk, Claus and Sørensen, Carsten, Dynamic Asset Allocation with Stochastic Income and Interest Rates (March 26, 2009). EFA 2006 Zurich Meetings. Available at SSRN: https://ssrn.com/abstract=676021 or http://dx.doi.org/10.2139/ssrn.676021

Claus Munk (Contact Author)

Copenhagen Business School ( email )

Department of Finance
Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

HOME PAGE: http://sites.google.com/view/clausmunk/home

Carsten Sørensen

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

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