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Portfolio choice, liquidity constraints and stock market mean reversion

Michaelides, Alexander (2001) Portfolio choice, liquidity constraints and stock market mean reversion. 2823. Centre for Economic Policy Research, London, UK.

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Abstract

This Paper solves numerically for the optimal consumption and portfolio choice of an infinitely lived investor facing short sales and borrowing constraints, undiversifiable labour income risk and a predictable time varying equity premium. The investor aggressively times the market while positive correlation between permanent earnings shocks and stock return innovations generates a substantial hedging demand for the riskless asset. Moreover, a speculative increase in savings arises when stock returns are expected to be high and conversely when future returns are expected to be low. Small information/optimization costs can make it optimal for an investor to assume i.i.d excess stock returns, both because liquidity constraints can be frequently binding and because households can smooth idiosyncratic earnings shock using a small buffer stock of wealth.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.cepr.org
Additional Information: © 2001 Alex Michaelides
Library of Congress subject classification: H Social Sciences > HG Finance
Journal of Economic Literature Classification System: G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice; Investment Decisions
E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Employment, and Investment > E21 - Macroeconomics: Consumption; Saving; Aggregate Physical and Financial Consumer Wealth
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Departments > Economics
Collections > LSE Financial Markets Group (FMG) Working Papers
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 2823
Date Deposited: 04 Jun 2008 16:52
URL: http://eprints.lse.ac.uk/5366/

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