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Risk aversion and optimal portfolio policies in partial and general equilibrium

Subject

Finance

Publishing details

IFA Working Paper

Authors / Editors

Kogan L;Uppal R

Publication Year

2001

Abstract

In this article, we examine analytically the optimal consumption and portfolio policies in an economy where agents derive utility from intermediate consumption and bequest, face portfolio constraints, and the investment opportunity set is stochastic. The source of changes in the investment opportunity set could be a stochastic instantaneous interest rate, stochastic volatility, and/or a stochastic risk premium. We find analytically the conditions under which investment in the risky asset can increase with risk aversion. We then nest this portfolio problem in a general equilibrium setting (for a production economy and also for an exchange economy) with multiple agents who differ in their degree of risk aversion. We derive the optimal portfolio policies when the evolution of the investment opportunity set is determined endogenously and also characterize explicitly the interest rate, stock price and risk premium in general equilibrium. The exact comparative statics and approximate but analytical expressions for the optimal policies are obtained by developing a method based on asymptotic analysis to expand around the solution for an investor with log utility. JEL classification: G11, D81 Keywords: Portfolio choice, uncertainty, ambiguity, robust control

Publication Research Centre

Institute of Finance and Accounting

Series Number

FIN 332

Series

IFA Working Paper

Available on ECCH

No


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