RFS Advance Access published online on June 10, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp040
Dynamic Asset Allocation: Portfolio Decomposition Formula and Applications
Boston University School of Management
Boston University School of Management
Send correspondence to Jérôme Detemple, Boston University School of Management, 595 Commonwealth Avenue, Boston, MA 02215; telephone: (617) 353-4297; fax: (617) 353-6667. E-mail: detemple{at}bu.edu.
JEL Classification: G11
 |
Abstract |
|---|
A new decomposition of the optimal portfolio, in dynamic models with von Neumann–Morgenstern preferences and Ito prices, is established. The formula rests on a change of numéraire that uses pure discount bonds as units of account. The dynamic hedging demand has two components. The first hedge insures against fluctuations in an optimally designed bond with a maturity date matching the investor's horizon. The second hedge immunizes against fluctuations in the market price of risk in the bond numéraire. Various applications are examined. New results concerning the behavior of extremely risk-averse individuals, the demand for bonds and its long-horizon limit, and the optimal portfolio in incomplete markets are derived.
This paper was presented at Boston University, Université de Lausanne, University of British Columbia, Princeton University, Norwegian School of Management, Copenhagen Business School, National University of Singapore, the 2006 BIRS Workshop on Optimization Problems in Financial Economics (Banff), the 2006 INFORMS International Conference (Hong Kong), the 2006 World Congress of the Bachelier Finance Society (Tokyo), the 2006 Northern Finance Association meetings (Montréal), and the 2007 Econometric Society meetings (Chicago). We thank Bernard Dumas and seminar participants for their comments. We would also like to thank two anonymous referees and the editor for useful and constructive comments.