Portfolio Choice and Equity Characteristics: Characterizing the Hedging Demands Induced by Return Predictability

Anthony W. Lynch

New York University, Leonard N. Stern School Finance Department Working Paper Seires from New York University, Leonard N. Stern School of Business-

Abstract: This paper examines portfolio allocation across equity portfolios formed on the basis of characteristics like size and book-to- market. In particular, the paper assesses the impact of return predictability on portfolio choice for a multi-period investor with a coefficient of relative risk aversion of 4. Compared to the investor’s allocation in her last period, return predictability with dividend yield causes the investor early in life to tilt her risky-asset portfolio away from high book-to-market stocks and away from small stocks. These results are explained using Merton’s (1973) characterization of portfolio allocation by a multiperiod investor in a continuous time setting. Abnormal returns relative to the investor’s optimal early-life portfolio are also calculated. These abnormal returns are found to exhibit the same cross-sectional patterns as abnormal returns calculated relative to the market portfolio: higher for small than large firms, and higher for high than low book-to-market firms. Thus, hedging demand may be a partial explanation for the high expected returns documented empirically for small firms and high book-to-market firms. However, even with this hedging demand, the investor wants to short-sell the low book-to market portfolio to hold the high book-to-market portfolio. The utility costs of using a value-weighted equity index or of ignoring predictability are also calculated. An investor using a value-weighted equity index would give up a much larger fraction of her wealth to have access to book-to-market portfolios than size portfolios. Finally, while an investor would give up a much larger fraction of her wealth to have access to dividend yield information than term spread information, term spread does have incremental benefits over and above just using dividend yield alone.

Date: 2000-02
New Economics Papers: this item is included in nep-fin and nep-fmk
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

Downloads: (external link)
http://www.stern.nyu.edu/fin/workpapers/papers99/wpa99073.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found (http://www.stern.nyu.edu/fin/workpapers/papers99/wpa99073.pdf [301 Moved Permanently]--> https://www.stern.nyu.edu/fin/workpapers/papers99/wpa99073.pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fth:nystfi:99-073

Access Statistics for this paper

More papers in New York University, Leonard N. Stern School Finance Department Working Paper Seires from New York University, Leonard N. Stern School of Business- U.S.A.; New York University, Leonard N. Stern School of Business, Department of Economics . 44 West 4th Street. New York, New York 10012-1126. Contact information at EDIRC.
Bibliographic data for series maintained by Thomas Krichel (krichel@openlib.org).