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RFS Advance Access published online on September 17, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp058
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© The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

When Can Life Cycle Investors Benefit from Time-Varying Bond Risk Premia?

Ralph S. J. Koijen
University of Chicago, Booth School of Business

Theo E. Nijman
Finance and Econometrics Group, CentER, Netspar, Tilburg University

Bas J. M. Werker
Finance and Econometrics Group, CentER, Netspar, Tilburg University

Send correspondence to Ralpha S. J. Koijen at the University of Chicago, Booth School of Business, 5807 South Woodlawn Avenue, Chicago, IL 60637; telephone: (773) 834-4199; fax: (773) 702-0458. E-mail: Ralph.Koijen{at}Chicagogsb.edu

JEL Classification: G110


  Abstract

We study the importance of time-varying bond risk premia in a consumption and portfolio-choice problem for a life-cycle investor facing short-sales and borrowing constraints. Tilts in the optimal asset allocation in response to changes in bond risk premia exhibit pronounced life-cycle patterns. We find that the investor is willing to pay an annual fee up to 1% to implement a strategy that optimally conditions on prevailing bond risk premia in addition to her age and wealth. To solve our model, we extend recently developed simulation-based techniques to life-cycle problems featuring multiple state variables and multiple risky assets.

We are grateful to an anonymous referee, Jules van Binsbergen, Lans Bovenberg, Michael Brandt, Laurent Calvet, John Cochrane, Greg Duffee, Thijs van der Heijden, Frank de Jong, Martin Lettau, Hanno Lustig, Claus Munk, Viorel Roscovan, Antonios Sangvinatsos, Hans Schumacher, Ken Singleton, Georgios Skoulakis, Carsten Sorensen, Raman Uppal (editor), Otto Van Hemert, Stijn Van Nieuwerburgh, Luis Viceira, Rui Yao, and seminar participants at Duke University—Fuqua School of Business, University of Maastricht, Tilburg University, 2007 EFA Meetings (Ljubljana), 2007 WFA Meetings (Montana), the Imperial College Financial Econometrics Conference London, and the 5th Winterschool of Financial Mathematics for helpful comments and suggestions. Ralpha S. J. Koijen is also associated with Netspar (Tilburg University).


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