Conditional Asset Allocation, Hedging and Intertemporal Asset Pricing

Abstract

We jointly estimate and test a conditional asset pricing model which includes long term interest rate risk as a potentially priced factor for four broad classes of assets - large stocks, small stocks, long term Treasury bonds and corporate bonds. We find that the premium for long bond risk is the main component of the risk premiums of Treasury bond and corporate bond portfolios, while it represents a small fraction of total risk premiums for equities. Our results suggest that investors perceive stocks as hedges against variations in the investment opportunity set. Since these four asset classes represent some of the most important for investors, we proceed to use our estimates to compute the optimal period by period asset allocations for investors with different risk preferences and trading strategies. We decompose the trades in their market timing, hedging and speculative components.