DYNAMIC PORTFOLIO MANAGEMENT UNDER RISK AND SUBSISTENCE CONSTRAINTS IN DEVELOPING COUNTRIES

Frederic Zimmerman and Michael Carter

No 402, Staff Papers from University of Wisconsin Madison, AAE

Abstract: This paper presents a model that endogenizes asset-based risk- coping in an environment of unmediated risk and subsistence constraints. It uses an individually-rational, stochastic dynamic programming model to explore intertemporal portfolio decisions in an environment in which both yield risk and endogenous asses-price risk exist. The results show that agents pursue one the three distinct investment strategies, depending on their initial wealth levels. Agents who are too poor to support subsistence at a sustainable level eventually stock out, driving their asset base to zero. Agents who have more than a certain threshold level of highly productive assets continue to accumulate those assets. Agents who fall somewhere in between, with an intermediate level of assets, adjust their portfolios to maintain both their yield risk and their price risk at a tolerable level.

The paper compares the portfolio management strategies of the intermediate group ("poor") and the wealthy group. It is found that the poor pursue strategies that involve smoother income but less smooth consumption than is the case for the wealthy. This result at once provides a theoretical explanation for recent empirical findings of a positive correlation between wealth and rates of return on portfolios in South India, and at the same time suggests that a common explanation for this phenomenon--that of decreasing relative risk aversion--is probably inaccurate.

Date: 1996-11
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Citations: View citations in EconPapers (7)

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