Working Paper: CEPR ID: DP3144
Authors: Thomas Flavin; Michael R. Wickens
Abstract: We develop a tactical asset allocation strategy that incorporates the effects of macroeconomic variables. The joint distribution of financial asset returns and the macroeconomic variables is modelled using a VAR with an M-GARCH error structure. As a result the portfolio frontier is time varying and subject to contagion from the macroeconomic variable. Optimal asset allocation requires that this be taken into account. We illustrate the how to do this using three risky UK assets and inflation as a macroeconomic factor. Taking account of inflation generates portfolio frontiers that lie closer to the origin, and offers investors superior risk-return combinations.
Keywords: asset allocation; macroeconomic effects; multivariate GARCH
JEL Codes: G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| macroeconomic volatility (E39) | asset return volatility (G17) |
| inflation (E31) | asset return volatility (G17) |
| inflation (E31) | optimal asset allocation (G11) |
| asset return volatility (G17) | tactical asset allocation strategies (G11) |
| time-varying portfolio frontier (G11) | continuous rebalancing of asset shares (G11) |