Business Intelligence

Is The Volatility Of The Market Price Of Risk Due To Intermittent Portfolio Re-Balancing?

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Executive Summary

The paper examines whether intermittent portfolio re-balancing on the part of some stock market investors can help to explain the counter-cyclical volatility of aggregate risk compensation in financial markets. To answer this question, an incomplete markets model was set up in which CRRA-utility investors are subject to aggregate and idiosyncratic shocks and have heterogeneous trading technologies. In the model, a large mass of passive investors do not re-balance their portfolio shares in response to aggregate shocks, while a smaller mass of active investors adjust their portfolio each period to respond to changes in the investment opportunity set. It's found that intermittent re-balancers amplify the effect of aggregate shocks on the time variation in risk premia by a factor of four in a calibrated version of the model.

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