Working Paper: NBER ID: w10086
Authors: Antonios Sangvinatsos; Jessica A. Wachter
Abstract: We consider the consumption and portfolio choice problem of a long-run investor when the term structure is affine and when the investor has access to nominal bonds and a stock portfolio. In the presence of unhedgeable inflation risk, there exist multiple pricing kernels that produce the same bond prices, but a unique pricing kernel equal to the marginal utility of the investor. We apply our method to a three-factor Gaussian model with a time-varying price of risk that captures the failure of the expectations hypothesis seen in the data. We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio for the long-run investor looks very different from the portfolio of a mean-variance optimizer. In particular, the desire to hedge changes in term premia generates large hedging demands for long-term bonds.
Keywords: No keywords provided
JEL Codes: G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| failure of the expectations hypothesis (D84) | changes in optimal portfolio allocations for long-term investors (G11) |
| time-varying risk premia (C22) | allocation to long-term bonds (G12) |
| investment horizon (G11) | allocation to long-term bonds (G12) |
| failure to hedge time variations (C41) | high utility costs for the investor (L97) |
| myopic strategies (L21) | suboptimal outcomes for the investor (G11) |
| real risk-free rate (E43) | investor behavior (G41) |