We develop a new framework for multivariate intertemporal portfolio choice that allows us to derive optimal portfolio implications for economies in which the degree of correlation across industries, countries, or asset classes is stochastic. Optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk. We find that the hedging demand is typically larger than in univariate models, and it includes an economically significant covariance hedging component, which tends to increase with the persistence of variance-covariance shocks, the strength of leverage effects, the dimension of the investment opportunity set, and the presence of portfolio constraints.
The local robustness properties of generalized method of moments (GMM) estimators and of a broad class of GMM based tests are investigated in a unified framework. GMM statistics are shown to have bounded influence if and only if the function defining the orthogonality restrictions imposed on the underlying model is bounded. Since in many applications this function is unbounded, it is useful to have procedures that modify the starting orthogonality conditions in order to obtain a robust version of a GMM estimator or test. We show how this can be obtained when a reference model for the data distribution can be assumed. We develop a flexible algorithm for constructing a robust GMM (RGMM) estimator leading to stable GMM test statistics. The amount of robustness can be controlled by an appropriate tuning constant. We relate by an explicit formula the choice of this constant to the maximal admissible bias on the level or (and) the power of a GMM test and the amount of contamination that one can reasonably assume given some information on the data. Finally, we illustrate the RGMM methodology with some simulations of an application to RGMM testing for conditional heteroscedasticity in a simple linear autoregressive model. In this example we find a significant instability of the size and the power of a classical GMM testing procedure under a non-normal conditional error distribution. On the other side, the RGMM testing procedures can control the size and the power of the test under non-standard conditions while maintaining a satisfactory power under an approximatively normal conditional error distribution
We present a geometric approach to discrete time multiperiod mean variance portfolio optimization that largely simplifies the mathematical analysis and the economic interpretation of such model settings. We show that multiperiod mean variance optimal policies can be decomposed in an orthogonal set of basis strategies, each having a clear economic interpretation. This implies that the corresponding multi period mean variance frontiers are spanned by an orthogonal basis of dynamic returns. Specifically, in a k−period model the optimal strategy is a linear combination of a single k−period global minimum second moment strategy and a sequence of k local excess return strategies which expose the dynamic portfolio optimally to each single-period asset excess return. This decomposition is a multi period version of Hansen and Richard (1987) orthogonal representation of single-period mean variance frontiers and naturally extends the basic economic intuition of the static Markowitz model to the multiperiod context. Using the geometric approach to dynamic mean variance optimization we obtain closed form solutions in the i.i.d. setting for portfolios consisting of both assets and liabilities (AL), each modelled by a distinct state variable. As a special case, the solution of the mean variance problem for the asset only case in Li and Ng (2000) follows directly and can be represented in terms of simple products of some single period orthogonal returns. We illustrate the usefulness of our geometric representation of multi-periods optimal policies and mean variance frontiers by discussing specific issued related to AL portfolios: The impact of taking liabilities into account on the implied mean variance frontiers, the quantification of the impact of the investment horizon and the determination of the optimal initial funding ratio.
We propose a new continuous time framework to study asset prices under learning and ambiguity aversion. In a partial information Lucas economy with time additive power utility, a discount for ambiguity arises if and only if the elasticity of intertemporal substitution (EIS) is above one. Then, ambiguity increases equity premia and volatilities, and lowers interest rates. Very low EIS estimates are consistent with EIS parameters above one, because of a downward bias in Euler-equations-based least squares regressions. In our setting, ambiguity does not resolve asymptotically and, for high EIS, it is consistent with the equity premium, the low interest rate, and the excess volatility puzzles.
We develop a new framework for multivariate intertemporal portfolio choice that allows us to derive optimal portfolio implications for economies in which the degree of correlation across industries, countries, or asset classes is stochastic. Optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk. We find that the hedging demand is typically larger than in univariate models, and it includes an economically significant covariance hedging component, which tends to increase with the persistence of variance-covariance shocks, the strength of leverage effects, the dimension of the investment opportunity set, and the presence of portfolio constraints. Copyright (c) 2009 the American Finance Association.
We provide novel evidence for an equilibrium link between investors' disagreement, the market price of volatility and correlation, and the differential pricing of index and individual equity options. We show that belief disagreement is positively related to (i) the wedge between index and individual volatility risk premia, (ii) the different slope of the smile of index and individual options, and (iii) the correlation risk premium. Priced disagreement risk also explains returns of option volatility and correlation trading strategies in a way that is robust to the inclusion of other risk factors and different market conditions.
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