Dynamic asset allocation with stochastic income and interest rates |
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Authors: | Claus Munk Carsten Sørensen |
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Institution: | 1. School of Economics and Management and Department of Mathematical Sciences, Aarhus University, Bartholin''s Alle 10, DK-8000 Aarhus C, Denmark;2. Department of Finance, Copenhagen Business School, Denmark |
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Abstract: | We solve for optimal portfolios when interest rates and labor income are stochastic with the expected income growth being affine in the short-term interest rate in order to encompass business cycle variations in wages. Our calibration based on the Panel Study of Income Dynamics (PSID) data supports this relation with substantial variation across individuals in the slope of this affine function. The slope is crucial for the valuation and riskiness of human capital and for the optimal stock/bond/cash allocation both in an unconstrained complete market and in an incomplete market with liquidity and short-sales constraints. |
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Keywords: | Portfolio management Labor income risk Interest rate risk Business cycle Life-cycle |
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