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Working Paper Series - Strategic Asset Allocation in Stochastic Environment and Incomplete Markets : Evidence on Horizon and Hedging Effects



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Strategic Asset Allocation in Stochastic Environment and Incomplete Markets : Evidence on Horizon and Hedging Effects


Volume : 0

No : 0

ISSN : WPS0603

Publisher : Arab Planning Institute - Kuwait

Author (s) : Ahmed Telfah

Published Date : 1/1/2006


Contents :
The paper analyzes optimalportfolio choice when the investment opportunity set is driven bymulti-stochastic factors, namely; stochastic interest rates, stochasticvolatility and stochastic inflation. The analysis is implemented in anincomplete market setting, where the number of risk sources is larger than thenumber of risky assets. The model segregates the effect of inflation from theother two state variables by deriving the dynamics in real wealth. The derivedoptimal portfolio shows that inflation plays a significant role in forminginvestors’ hedging demand through the correlation structure between inflationand assets held in the portfolio. Empirically, the paper calibrates the optimalportfolio choice for different classes of investors distinct by the degree ofrisk tolerance and investment horizon length in an attempt to mimic the popularfinancial planners’ advice. Calibration results show that the joint inclusionof stochastic interest rates, stochastic volatility and stochastic inflationintroduces a plausible simultaneous resolution for both Samuelson puzzle andasset allocation puzzle of Canner, Mankiw, and Weil (1997).


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