Working Paper: NBER ID: w15382
Authors: Yili Chien; Harold L. Cole; Hanno Lustig
Abstract: Our paper examines whether the well-documented failure of unsophisticated investors to rebalance their portfolios can help to explain the enormous counter-cyclical volatility of aggregate risk compensation in financial markets. To answer this question, we set up a model in which CRRA-utility investors have heterogeneous trading technologies. In our model, a large mass of investors do not re-balance their portfolio shares in response to aggregate shocks, while a smaller mass of active investors adjust their portfolio each period to respond to changes in the investment opportunity set. We find that these intermittent re-balancers more than double the effect of aggregate shocks on the time variation in risk premia by forcing active traders to sell more shares in good times and buy more shares in bad times.
Keywords: Market Price of Risk; Portfolio Rebalancing; Risk Compensation
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| intermittent rebalancing by passive investors (G11) | increased volatility in risk prices (G19) |
| intermittent rebalancers (D52) | concentration of aggregate risk among active traders (G41) |
| concentration of aggregate risk among active traders (G41) | countercyclical volatility in risk prices (E32) |
| intermittent rebalancers (D52) | amplification of risk premia (G40) |
| intermittent rebalancing (D52) | significant aggregate effects on market volatility (C58) |