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Dynamic asset allocation and latent variables

Author

Listed:
  • Sørensen, Carsten

    (Department of Finance, Copenhagen Business School)

  • Trolle, Anders Bjerre

    (Department of Finance, Copenhagen Business School)

Abstract
We derive an explicit solution to the portfolio problem of a power utility investor with preferences for wealth at a ¯nite investment horizon. The investor can invest in assets with return dynamics described as part of a general multivariate model. The modeling framework encompasses discrete-time VAR-models where some of the state-variables (e.g. expected excess returns) may not be directly observable. A realistic multivariate model is estimated and applied to analyze the portfolio implications of investment horizon and return predictability when real interest rates and expected excess returns on stock and bonds are not directly observed but must be estimated as part of the problem faced by the investor. The solution exhibits small variability in portfolio allocations over time compared to the case when excess returns are assumed observable.

Suggested Citation

  • Sørensen, Carsten & Trolle, Anders Bjerre, 2006. "Dynamic asset allocation and latent variables," Working Papers 2004-8, Copenhagen Business School, Department of Finance.
    • Handle: RePEc:hhs:cbsfin:2004_008
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    File URL: http://openarchive.cbs.dk/cbsweb/handle/10398/7151
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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Portfolio choice; predictability; VAR; unobserved state-variables; hedging demands;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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