Optimal consumption and portfolio choice in the presence of long-run risk
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| Title | Optimal consumption and portfolio choice in the presence of long-run risk
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| Author | Wang Zhizheng and Wu Weixing |
| Organization | Research Center for Applied Finance，School of Banking and Finance, University of International Business |
| Email | xnjrong@nwsuaf.edu.cn；Wxwu@uibe.edu.cn |
| Key Words | Risk Aversion; Elasticity of Intertemporal Substitution; Equity Premium; Consumption-wealth Ratio |
| Abstract | In recent academic research, the shock to expected consumption growth rate is labeled as long-run risk, and has been applied to asset pricing study. To some extent, long-run risk explains the equity premium. This paper presents an approximate analytical solution to the optimal consumption and portfolio allocation for infinite-lived investors who has the recursive utility in the presence of long-run risk. Using the calibration parameters and centering the different values of RRA and EIS, we find that when the coefficient of relative risk aversion (RRA) and elasticity of intertemporal substitution (EIS) are larger, there are the smaller risk-free interest rate, but higher risk premium, the bigger Sharpe ratio and HJ border in the market. The consumption rules of investor are very sensitive to EIS and RRA. The consumption-wealth ratio of investor is higher for the combination of higher EIS and RRA, or of lower EIS and RRA. On the contrary, the consumption-wealth ratio is lower. Total demand of risk assets can be divided into myopic demand capturing a risk premium and hedging demand capturing the intertemporal risk. The total demand of risk asset increases with increasing RRA, but show the trend of first increase after reduction with a rise in EIS. |
| Serial Number | WP837 |
| Time | 2015-03-17 |
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