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Dynamic Consumption and Portfolio Choice with Ambiguity about Stochastic Volatility

Gonçalo Faria (), Joao Correia-da-Silva and Cláudia Ribeiro ()
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Cláudia Ribeiro: CEF.UP, Faculdade de Economia, Universidade do Porto

FEP Working Papers from Universidade do Porto, Faculdade de Economia do Porto

Abstract: We introduce ambiguity about the variance of the risky asset's return in the model of Chacko and Viceira (2005) for dynamic consumption and portfolio choice with stochastic variance. We find that, with investors being able to update their portfolio continuously (as a function of the instantaneous variance), ambiguity has no impact. To shed some light on the case in which continuous portfolio updating is not possible, we also evaluate the effect of ambiguity when investors must use their expectation of future variance for their portfolio decision. In the latter scenario, demand for the risky asset can be decomposed into three components: myopic and intertemporal hedging demands (as in Chacko and Viceira (2005)) and ambiguity demand. Using long-run US data, Chacko and Viceira (2005) found that intertemporal hedging demand is empirically small, suggesting a low impact of stochastic variance on portfolio choice. Using the same calibration, we find that ambiguity demand may be very high, much more than intertemporal hedging demand. Therefore, stochastic variance can be very relevant for portfolio choice, not because of the variance risk, but because of investors' ambiguity about variance.

Keywords: Asset Allocation; Stochastic Volatility; Ambiguity (search for similar items in EconPapers)
JEL-codes: C61 D81 E21 G11 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2009-12
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Citations: View citations in EconPapers (2)

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