Dynamic Portfolio Choice under Ambiguity and Regime Switching Mean Returns
40 Pages Posted: 26 Jul 2010 Last revised: 15 Jan 2011
Date Written: December 15, 2010
Abstract
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. We explicitly characterize optimal consumption and portfolio policies 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.
Keywords: Hidden Markov model, Malliavin derivative, portfolio choice, recursive multiple priors
JEL Classification: G11, D81, C61
Suggested Citation: Suggested Citation
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