Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets

Posted: 29 Feb 2008

See all articles by George Chacko

George Chacko

Santa Clara University - Finance Department

s M. Viceira

affiliation not provided to SSRN

Multiple version iconThere are 3 versions of this paper

Date Written: 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 which 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 U.S. 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.

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Suggested Citation

Chacko, George and Viceira, s M., Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets ( 2005). The Review of Financial Studies, Vol. 18, Issue 4, pp. 1369-1402, 2005, Available at SSRN: https://ssrn.com/abstract=900705

George Chacko (Contact Author)

Santa Clara University - Finance Department ( email )

Santa Clara, CA 95053
United States

S M. Viceira

affiliation not provided to SSRN

No Address Available

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