Joint Computational Finance and Finance Department Seminar
This talk proposes a new tractable approach to solving asset allocation problems in situations with a large number of risky assets which pose problems for standard numerical approaches. Investor preferences are assumed to be defined over moments of the wealth distribution such as its skew and kurtosis. Time-variations in investment opportunities are represented by a flexible regime switching process. We develop analytical methods that only require solving a small set of difference equations and can be applied even in the presence of large numbers of risky assets. We find evidence of two distinct bull and bear states in the joint distribution of equity returns in five major regions with correlations that are much higher in the bear state. Ignoring regimes, an unhedged US investor's optimal portfolio is strongly diversified internationally. Regimes in the return distribution leads to a large increase in the investor's optimal holdings of US stocks as does the introduction of predictability in returns from a short US interest rate. Our paper therefore offers a new explanation of the strong home bias observed in US investors' asset allocation, based on regime switching, skew and kurtosis preferences and predictability from the short US interest rate.
* Allan Timmermann is Professor of Management and Economics at the University of California San Diego. Previously he has taught at the London School of Economics and Stanford University. Professor Timmermann is a departmental editor of the Journal of Forecasting and an associate editor of Journal of Business and Economic Statistics, Journal of Economic Dynamics and Control and Journal of Financial Econometrics. Dr. Timmermann obtained his PhD from University of Cambridge and has published papers on predictability of stock market returns, technical trading rules and performance evaluation for mutual funds and pension funds as well as papers on a range of econometric issues related to regime switching, structural breaks and forecasting.