Strategic Asset Allocation in Stochastic Environment and Incomplete Markets: Evidence on Horizon and Hedging Effects

Abstract

The paper analyzes optimal portfolio choice when the investment opportunity set is driven by multi-stochastic factors, namely; stochastic interest rates, stochastic volatility and stochastic inflation. The analysis is implemented in an incomplete market setting, where the number of risk sources is larger than the number of risky assets. The model segregates the effect of inflation from the other two state variables by deriving the dynamics in real wealth. The derived optimal portfolio shows that inflation plays a significant role in forming investors’ hedging demand through the correlation structure between inflation and assets held in the portfolio. The correlation structure among assets seems to determine the speculation demand rather than the hedging demand. Empirically, the paper calibrates the optimal portfolio choice for different classes of investors distinct by the degree of risk tolerance and investment horizon length in an attempt to mimic the popular financial planners’ advice. Calibration results show that the joint inclusion of stochastic interest rates, stochastic volatility and stochastic inflation introduces a plausible simultaneous resolution for both Samuelson puzzle and asset allocation puzzle of Canner, Mankiw, and Weil (1997).