Dynamic Asset Allocation under Regime Switching, Predictability and Parameter Uncertainty
39 Pages Posted: 22 Oct 2012 Last revised: 28 Mar 2013
Date Written: March 25, 2013
Abstract
This paper solves the dynamic asset allocation problem under stock return predictability based on the dividend price ratio with regime shifts and parameter uncertainty in a fully Bayesian framework. Intertemporal hedging demands are simultaneously induced by predictability, regime shifts, parameter uncertainty, and learning about the regimes. Optimal policies display non-monotonic horizon effects whereby regime shifts tend to induce negative hedge demands in the short-run, while predictability induces positive hedge demands in the long-run. The economic costs of ignoring regime switching and predictability are high even in the light of regime and parameter uncertainty.
Keywords: Portfolio choice, Gibbs sampling, Dividend price ratio, Estimation risk
JEL Classification: G11, G17, C11
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