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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27225
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| Title: | Portfolio Choice and Equity Characteristics: Characterizing the Hedging Demands |
| Authors: | Lynch, Anthony W. |
| Issue Date: | Mar-1999 |
| Series/Report no.: | FIN-99-073 |
| Abstract: | This paper examines portfolio allocation across equity portfolios formed
on the basis of characteristics like size and book-to-market. In
particular, the paper assesses the impact of return predictability on
portfolio choice for a multi-period investor with a coefficient of
relative risk aversion of 4. Compared to the investor's allocation in
her last period, return predictability with dividend yield causes the
investor early in life to tilt her risky-asset portfolio away from high
book-to-market stocks and away from small stocks. These results are
explained using Merton's (1973) characterization of portfolio allocation
by a multiperiod investor in a continuous time setting. Abnormal returns
relative to the investor’s optimal early-life portfolio are also
calculated. These abnormal returns are found to exhibit the same
cross-sectional patterns as abnormal returns calculated relative to the
market portfolio: higher for small than large firms, and higher for high
than low book-to-market firms. Thus, hedging demand may be a partial
explanation for the high expected returns documented empirically for
small firms and high book-to-market firms. However, even with this
hedging demand, the investor wants to short-sell the low book-to market
portfolio to hold the high book-to-market portfolio. The utility costs
of using a value-weighted equity index or of ignoring predictability are
also calculated. An investor using a value-weighted equity index would
give up a much larger fraction of her wealth to have access to
book-to-market portfolios than size portfolios. Finally, while an
investor would give up a much larger fraction of her wealth to have
access to dividend yield information than term spread information |
| URI: | http://hdl.handle.net/2451/27225 |
| Appears in Collections: | Finance Working Papers
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