Dynamic portfolio choice under ambiguity and regime switching mean returns

Hening Liu

I examine a continuous-time intertemporal consumption and portfolio choice problem under ambiguity, where expected returns of a risky asset follow a hidden Markov chain. Investors with Chen and Epstein's (2002) recursive multiple priors utility possess a set of priors for unobservable investment opportunities. The optimal consumption and portfolio policies are explicitly characterized in terms of the Malliavin derivatives and stochastic integrals. When the model is calibrated to U.S. stock market data, I find that continuous Bayesian revisions under incomplete information generate ambiguity-driven hedging demands that mitigate intertemporal hedging demands. In addition, ambiguity aversion magnifies the importance of hedging demands in the optimal portfolio policies. Out-of-sample experiments demonstrate the economic importance of accounting for ambiguity.

Mots clés: Hidden Markov model; Malliavin derivative; Portfolio choice; Recursive multiple priors

Domaines: Économie et finance quantitative [q-fin]

Hening Liu. Dynamic portfolio choice under ambiguity and regime switching mean returns. Journal of Economic Dynamics and Control, 2011, 35 (4), pp.623. ⟨10.1016/j.jedc.2010.12.012⟩. ⟨hal-00781344⟩