Optimal Consumption and Portfolio Choice under Ambiguity for a Mean-reverting Risk Premium in Complete Markets

Hening Liu
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Hening Liu: Accounting and Finance, Manchester Business School, University of Manchester

Annals of Economics and Finance, 2013, vol. 14, issue 1, 21-52

Abstract: This paper explicitly solves, in closed form, the optimal consumption and portfolio choice for an ambiguity averse investor in a Merton-type two assets economy where a risk premium follows a mean-reverting process. The investor's preferences are represented by the recursive multiple priors utility model developed by Chen and Epstein (2002). The investor's utility depends on both intermediate consumption and terminal wealth. Under the assumption of complete markets, I use the martingale method to solve the dynamic optimization problem in continuous time. I find that ambiguity can decrease the optimal consumption-to-wealth ratio, the intertemporal hedging demand and the optimal portfolio allocation, but magnifies the importance of hedging demand in the optimal portfolio allocation. In addition, ambiguity also increases riskless savings.

Keywords: Ambiguity; Mean-reverting; Portfolio choice; Recursive multiple priors (search for similar items in EconPapers)
JEL-codes: C61 D81 G11 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:cuf:journl:y:2013:v:14:i:1:n:2:liu

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