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Giannis Vardas () and Anastasios Xepapadeas ()

International Journal of Theoretical and Applied Finance (IJTAF), 2007, vol. 10, issue 06, 985-1014

Abstract: We formulate the portfolio choice problem as a robust control problem under uncertainty or ambiguity aversion. By considering a stochastic investment opportunity set, we derive optimal robust portfolio rules in the cases of one and two risky assets. With two risky assets and ambiguity structure determined by economy-wide factors, we show that the robust portfolio rule could lead to an increase in the total holdings of risky assets as compared to the holdings under the Merton rule, which is the standard risk aversion case. This result goes against the general belief that uncertainty aversion and robust control methods lead to conservative behavior. We also show that the investor is more likely to increase the holdings of the asset for which there is no ambiguity, and reduce the holdings of the asset for which there is ambiguity, a result that might provide an explanation for the home bias puzzle.

Keywords: Uncertainty aversion; model misspecification; robust control; portfolio choice models (search for similar items in EconPapers)
Date: 2007
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DOI: 10.1142/S0219024907004524

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International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

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