Consumption and Portfolio Choice over the Life Cycle

This article solves a realistically calibrated life cycle modelof consumption and portfolio choice with non-tradable laborincome and borrowing constraints. Since labor income substitutesfor riskless asset holdings, the optimal share invested in equitiesis roughly decreasing over life. We compute a measure of theimportance of human capital for investment behavior. We findthat ignoring labor income generates large utility costs, whilethe cost of ignoring only its risk is an order of magnitudesmaller, except when we allow for a disastrous labor incomeshock. Moreover, we study the implications of introducing endogenousborrowing constraints in this incomplete-markets setting.     

Stock Market Mean Reversion and the Optimal Equity Allocation of a Long-Lived Investor

This paper solves numerically the intertemporalconsumption and portfolio choiceproblem of an infinitely-lived investor whofaces a time-varying equity premium.The solutions we obtain are very similarto the approximate analytical solutionsof Campbell and Viceira (1999), except atthe upper extreme of the state spacewhere both the numerical consumption andportfolio rules flatten out.We also consider a constrained version ofthe problem in which the investor facesborrowing and short-sales restrictions.These constraints bind when the equitypremium moves away from its mean in eitherdirection, and are particularly severe forrisk-tolerant investors. The constraints havesubstantial effects on optimalconsumption, but much more modest effects onoptimal portfolio choice in theregion of the state space where they are notbinding.     

Individual stock-option prices and credit spreads

This paper introduces measures of volatility and jump risk that are based on individual stock options to explain credit spreads on corporate bonds. Implied volatilities of individual options are shown to contain useful information for credit spreads and improve on historical volatilities when explaining the cross-sectional and time-series variation in a panel of corporate bond spreads. Both the level of individual implied volatilities and (to a lesser extent) the implied-volatility skew matter for credit spreads. Detailed principal component analysis shows that a large part of the time-series variation in credit spreads can be explained in this way.     

The world price of jump and volatility risk

We study international integration of markets for jump and volatility risk, using index option data for the main global markets. To explain the cross-section of expected option returns we focus on return-based multi-factor models. For each market separately, we provide evidence that volatility and jump risk are priced risk factors. There is little evidence, however, of global unconditional pricing of these risks. We show that UK and US option markets have become increasingly interrelated, and using conditional pricing models generates some evidence of international pricing. Finally, the benefits of diversifying jump and volatility risk internationally are substantial, but declining.     

Robust Portfolio Rules and Asset Pricing

I present a new approach to the dynamic portfolio and consumptionproblem of an investor who worries about model uncertainty (inaddition to market risk) and seeks robust decisions along thelines of Anderson, Hansen, and Sargent (2002). In accordancewith max-min expected utility, a robust investor insures againstsome endogenous worst case. I first show that robustness dramaticallydecreases the demand for equities and is observationally equivalentto recursive preferences when removing wealth effects. Unlikestandard recursive preferences, however, robustness leads toenvironment-specific "effective" risk aversion. As an extension,I present a closed-form solution for the portfolio problem ofa robust Duffie-Epstein-Zin investor. Finally, robustness increasesthe equilibrium equity premium and lowers the risk-free rate.Reasonable parameters generate a 4% to 6% equity premium.     

An Empirical Portfolio Perspective on Option Pricing Anomalies

We empirically study the economic benefits of giving investorsaccess to index options in the standard portfolio problem, analyzingboth expected-utility and nonexpected-utility investors in orderto understand who optimally buys and sells options. Using dataon S&P 500 index options, CRRA investors find it alwaysoptimal to short out-of-the-money puts and at-the-money straddles.The option positions are economically and statistically significantand robust to corrections for transaction costs, margin requirements,and Peso problems. Loss-averse and disappointment-averse investorsalso optimally hold short option positions. Only with highlydistorted probability assessments can we obtain positive portfolioweights for puts (cumulative prospect theory and anticipatedutility) and straddles (anticipated utility).