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Portfolio selection with randomly time-varying first and second moments: the role of the instantaneous capital market line

Author: Vassalou, M ; Nielsen, Lars TygeINSEAD Area: Finance Series: Working Paper ; 98/46/FIN Publisher: Fontainebleau : INSEAD, 1998.Language: EnglishDescription: 32 p.Type of document: INSEAD Working Paper Online Access: Click here Abstract: In the international portfolio selection model of Merton (1973), any change in means, variances or covariances returns is sufficient to generate a change in the investment opportunity set. Merton's formulation suggests that investors will hedge all such changes by including in their optimal portfolio holdings as many hedge funds as there are state variables that describe the dynamics of returns. In this paper, the author show that investors need to hedge only against changes in the radom slope and position of the instantaneous capital market line. If the instantaneous capital market line is constance or deterministic, then investors will not hold any hedge funds at all, even though means, variances and covariances of securities returns may be changing randomly over time. Based on these results, the author propose a new definition of the investment opportunity set and changes in the investment opportunity set. Thei analysis allows for incomplete markets and does not assume that the securities prices are Markovian. It provides a potential theoretical foundation for a certain conditional tests of asset princing models which ignore the intertemporal hedging premia.
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In the international portfolio selection model of Merton (1973), any change in means, variances or covariances returns is sufficient to generate a change in the investment opportunity set. Merton's formulation suggests that investors will hedge all such changes by including in their optimal portfolio holdings as many hedge funds as there are state variables that describe the dynamics of returns. In this paper, the author show that investors need to hedge only against changes in the radom slope and position of the instantaneous capital market line. If the instantaneous capital market line is constance or deterministic, then investors will not hold any hedge funds at all, even though means, variances and covariances of securities returns may be changing randomly over time. Based on these results, the author propose a new definition of the investment opportunity set and changes in the investment opportunity set. Thei analysis allows for incomplete markets and does not assume that the securities prices are Markovian. It provides a potential theoretical foundation for a certain conditional tests of asset princing models which ignore the intertemporal hedging premia.

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