Scandinavian Working Papers in Economics

Working Papers,
Copenhagen Business School, Department of Finance

No 2004-8: Dynamic asset allocation and latent variables

Carsten Sørensen and Anders Bjerre Trolle
Additional contact information
Carsten Sørensen: Department of Finance, Copenhagen Business School, Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark
Anders Bjerre Trolle: Department of Finance, Copenhagen Business School, Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark

Abstract: We derive an explicit solution to the portfolio problem of a power utility investor with preferences for wealth at a ¯nite investment horizon. The investor can invest in assets with return dynamics described as part of a general multivariate model. The modeling framework encompasses discrete-time VAR-models where some of the state-variables (e.g. expected excess returns) may not be directly observable. A realistic multivariate model is estimated and applied to analyze the portfolio implications of investment horizon and return predictability when real interest rates and expected excess returns on stock and bonds are not directly observed but must be estimated as part of the problem faced by the investor. The solution exhibits small variability in portfolio allocations over time compared to the case when excess returns are assumed observable.

Keywords: Portfolio choice; predictability; VAR; unobserved state-variables; hedging demands

JEL-codes: G11

55 pages, June 26, 2006

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