Knowledge that Transforms

Journal Article Cover Get access The Review of Financial Studies, Volume 23, Issue 10, October 2010, Page NP, https://doi.org/10.1093/rfs/hhq097 Published: 01 October 2010

Cover Get access The Review of Financial Studies, Volume 23, Issue 12, December 2010, Page NP, https://doi.org/10.1093/rfs/hhq133 Published: 01 December 2010

Cover Get access The Review of Financial Studies, Volume 23, Issue 11, November 2010, Page NP, https://doi.org/10.1093/rfs/hhq117 Published: 01 November 2010

Journal Article Cover Get access The Review of Financial Studies, Volume 23, Issue 9, September 2010, Page NP, https://doi.org/10.1093/rfs/hhq101 Published: 01 September 2010

Toronto and University of Warwick for helpful comments. All errors are our responsibility. Dynamic Mean-Variance Asset Allocation Mean-variance criteria remain prevalent in multi-period problems, and yet not much is known about their dynamically optimal policies. We provide a fully analytical characterization of the optimal dynamic mean-variance portfolios within a general incomplete-market economy, and recover a simple structure that also inherits several conventional properties of static models. We also identify a probability measure that incorporates intertemporal hedging demands and facilitates much tractability in the explicit computation of portfolios. We solve the problem by explicitly recognizing the time-inconsistency of the mean-variance criterion and deriving a recursive representation for it, which makes dynamic programming applicable. We further show that our time-consistent solution is generically different from the pre-commitment solutions in the extant literature, which maximize the mean-variance criterion at an initial date and which the investor commits to follow despite incentives to deviate. We illustrate the usefulness of our analysis by explicitly computing dynamic mean-variance portfolios under various stochastic investment opportunities in a straightforward way, which does not involve solving a Hamilton-Jacobi-Bellman

Traditional portfolio balance theory derives a downward sloping currency demand function from limited international asset substitutability. Historically, this theory enjoyed little empirical support. We provide direct evidence by examining the exchange rate effect of a major redefinition of the MSCI Global Equity Index in 2001 and 2002. The index redefinition implied large changes in the representation of different countries in the MSCI Global Equity Index and therefore produced strong exogenous equity flows by index funds. Our event study reveals that countries with a relatively increasing equity representation experienced a relative currency appreciation upon announcement of the index change. Moreover, stock markets that are upweighted (downweighted) feature a higher (lower) permanent comovement of their currency with the basket of other MSCI currencies.

This paper presents a dynamic equilibrium model of bond markets in which two groups of agents hold heterogeneous expectations about future economic conditions. The heterogeneous expectations cause agents to take on speculative positions against each other and therefore generate endogenous relative wealth fluctuation. The relative wealth fluctuation amplifies asset price volatility and contributes to the time variation in bond premia. Our model shows that a modest amount of heterogeneous expectations can help explain several puzzling phenomena, including the “excessive volatility” of bond yields, the failure of the expectations hypothesis, and the ability of a tent-shaped linear combination of forward rates to predict bond returns.

In the cross-section of U.S. households, the portfolio share in risky assets rises in wealth. The standard life-cycle model with power utility and non-tradable labor income has the counterfactual implication that the portfolio share declines in wealth. We develop a life-cycle model in which household utility depends on two types of consumption goods, basic and luxury. The model predicts that the expenditure share for basic goods declines in total consumption, and the variance of consumption growth rises in the level of consumption. When calibrated to match these two predictions in household consumption data, the model explains portfolio shares that rise in wealth. JEL classification: D11; D12; G11

We model how lobbying by interest groups affects the level of investor protection. In our model, insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future, compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors that operate to reduce investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, as well as the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future reduces but does not eliminate the distortions arising from insiders' interest in extracting rents from the capital public firms already have. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.