When Can Life-Cycle Investors Benefit from Time-Varying Bond Risk Premia?
Ralph S. J. Koijen
New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR)
Tilburg University - Center and Faculty of Economics and Business Administration
Bas J. M. Werker
Tilburg University - Center for Economic Research (CentER)
February 3, 2009
EFA 2007 Ljubljana Meetings Paper
We study the economic importance of time-varying bond risk premia in a life-cycle consumption and portfolio-choice problem for an investor facing short-sales and borrowing constraints. On average, the investor is able to time bond markets only as of age~45. Tilts in the optimal asset allocation in response to changes in bond risk premia exhibit pronounced life-cycle patterns. Taking as a point of reference an investor who conditions only on age and wealth, we compute the management fee this investor is willing to pay to account for either current risk premia or for both current and future risk premia. We find the fees to account for current risk premia to be economically sizeable, ranging up to 1\% per annum, but this fee is comparable to the fee of the fully optimal strategy. To solve our model, we extend recently developed simulation-based techniques to life-cycle problems featuring multiple state variables and multiple risky assets.
Number of Pages in PDF File: 49
Keywords: bond risk premia, life-cycle consumption, portfolio choice
JEL Classification: D91, E43, G11, G12
Date posted: March 1, 2007 ; Last revised: February 4, 2009