Department of Economics and Business Economics

Intertemporal Asset Allocation with Habit Formation in Preferences: An Approximate Analytical Solution

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Intertemporal Asset Allocation with Habit Formation in Preferences: An Approximate Analytical Solution. / Pedersen, Thomas Quistgaard.

Aarhus : Institut for Økonomi, Aarhus Universitet, 2008.

Research output: Working paper/Preprint Working paperResearch

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@techreport{9cf000b0bfa011ddabd8000ea68e967b,
title = "Intertemporal Asset Allocation with Habit Formation in Preferences: An Approximate Analytical Solution",
abstract = "In this paper we derive an approximate analytical solution to the optimal con-sumption and portfolio choice problem of an infinitely-lived investor with powerutility defined over the difference between consumption and an external habit. Theinvestor is assumed to have access to two tradable assets: a risk free asset withconstant return and a risky asset with a time-varying premium. We extend the ap-proach proposed by Campbell and Viceira (1999), which builds on log-linearizationsof the Euler equation, intertemporal budget constraint, and portfolio return, to alsocontain the log-linearized surplus consumption ratio. The {"}difference habit model{"}implies that the relative risk aversion is time-varying which is in line with recent ev-idence from the asset pricing literature. We show that accounting for habit a¤ectsboth the myopic and intertemporal hedge component of optimal asset demand, andintroduces an additional component that works as a hedge against changes in theinvestor's habit level. In an empirical application, we calibrate the model to U.S.data and show that habit formation has significant effects on both the optimalconsumption and portfolio choice compared to a standard CRRA utility function.",
keywords = "Intertemporal consumption and portfolio choice, habit formation, time-varying expected returns, time-varying risk aversion",
author = "Pedersen, {Thomas Quistgaard}",
year = "2008",
language = "English",
publisher = "Institut for {\O}konomi, Aarhus Universitet",
type = "WorkingPaper",
institution = "Institut for {\O}konomi, Aarhus Universitet",

}

RIS

TY - UNPB

T1 - Intertemporal Asset Allocation with Habit Formation in Preferences: An Approximate Analytical Solution

AU - Pedersen, Thomas Quistgaard

PY - 2008

Y1 - 2008

N2 - In this paper we derive an approximate analytical solution to the optimal con-sumption and portfolio choice problem of an infinitely-lived investor with powerutility defined over the difference between consumption and an external habit. Theinvestor is assumed to have access to two tradable assets: a risk free asset withconstant return and a risky asset with a time-varying premium. We extend the ap-proach proposed by Campbell and Viceira (1999), which builds on log-linearizationsof the Euler equation, intertemporal budget constraint, and portfolio return, to alsocontain the log-linearized surplus consumption ratio. The "difference habit model"implies that the relative risk aversion is time-varying which is in line with recent ev-idence from the asset pricing literature. We show that accounting for habit a¤ectsboth the myopic and intertemporal hedge component of optimal asset demand, andintroduces an additional component that works as a hedge against changes in theinvestor's habit level. In an empirical application, we calibrate the model to U.S.data and show that habit formation has significant effects on both the optimalconsumption and portfolio choice compared to a standard CRRA utility function.

AB - In this paper we derive an approximate analytical solution to the optimal con-sumption and portfolio choice problem of an infinitely-lived investor with powerutility defined over the difference between consumption and an external habit. Theinvestor is assumed to have access to two tradable assets: a risk free asset withconstant return and a risky asset with a time-varying premium. We extend the ap-proach proposed by Campbell and Viceira (1999), which builds on log-linearizationsof the Euler equation, intertemporal budget constraint, and portfolio return, to alsocontain the log-linearized surplus consumption ratio. The "difference habit model"implies that the relative risk aversion is time-varying which is in line with recent ev-idence from the asset pricing literature. We show that accounting for habit a¤ectsboth the myopic and intertemporal hedge component of optimal asset demand, andintroduces an additional component that works as a hedge against changes in theinvestor's habit level. In an empirical application, we calibrate the model to U.S.data and show that habit formation has significant effects on both the optimalconsumption and portfolio choice compared to a standard CRRA utility function.

KW - Intertemporal consumption and portfolio choice, habit formation, time-varying expected returns, time-varying risk aversion

M3 - Working paper

BT - Intertemporal Asset Allocation with Habit Formation in Preferences: An Approximate Analytical Solution

PB - Institut for Økonomi, Aarhus Universitet

CY - Aarhus

ER -