Working Paper: CEPR ID: DP13193
Authors: Thomas Gehrig; Leopold Sgner; Arne Westerkamp
Abstract: The implementation of parametric portfolio policies as introduced by Brandt, Santa Clara and Valkanov (RFS 2009) may run into empirical problems. For example, expected utility based on monthly returns of S&P-500 data from 1995-2013 turns non-monotonic for moderate levels of (constant) risk aversion. We establish that in the leading case of constant relative risk aversion (CRRA) strong assumptions on the properties of the returns, the variables used to implement the parametric portfolio policy and the parameter space are necessary to obtain a well defined optimization problem. Without such refinements an interior maximum of the expected utility functional may not exist. We provide economic conditions on the domain and/or the utility functions that overcome such empirical problems and that guarantee the effectiveness of the approach. We illustrate the implications of our improvements by applying parametric portfolio policies to a large universe of stocks.
Keywords: Portfolio Policy; Expected Utility; Risk Aversion; Prospect Theory
JEL Codes: C11; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk aversion (D81) | expected utility (D81) |
| risk aversion (D81) | portfolio performance (G11) |
| expected utility (D81) | non-existence of an interior maximum (C62) |
| utility functions (D11) | expected utility (D81) |
| transaction costs (D23) | expected utility (D81) |
| utility functions (negative returns) (D11) | portfolio optimization outcomes (G11) |