Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets

63 Pages Posted: 14 Jun 2005

See all articles by George Chacko

George Chacko

Santa Clara University - Finance Department

Luis M. Viceira

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2005

Abstract

This paper examines the optimal consumption and portfolio choice problem of long-horizon investors who have access to a riskless asset with constant return and a risky asset ('stocks') with constant expected return and time varying precision - the reciprocal of volatility. Markets are incomplete, and investors have recursive preferences defined over intermediate consumption. The paper obtains a solution to this problem that is exact for investors with unit elasticity of intertemporal substitution of consumption, and approximate otherwise. The optimal portfolio demand for stocks includes an intertemporal hedging component that is negative when investors have coefficients of relative risk aversion larger than one, and the instantaneous correlation between volatility and stock returns is negative, as typically estimated from stock return data. Our estimates of the joint process for stock returns and precision (or volatility) using US data confirm this finding. But we also find that stock return volatility does not appear to be variable and persistent enough to generate large intertemporal hedging demands.

Keywords: Long-horizon investing, dynamic portfolio choice, intertemporal hedging, stochastic volatility, spectral GMM, recursive utility

JEL Classification: G12

Suggested Citation

Chacko, George and Viceira, Luis M., Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets (February 2005). CEPR Discussion Paper No. 4913. Available at SSRN: https://ssrn.com/abstract=743114

George Chacko

Santa Clara University - Finance Department ( email )

Santa Clara, CA 95053
United States

Luis M. Viceira (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6331 (Phone)
617-496-6592 (Fax)

HOME PAGE: http://www.people.hbs.edu/lviceira

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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