Portfolio Choice with Many Risky Assets, Market Clearing and Cash Flow Predictability

Abstract

This paper examines portfolio allocations and market clearing prices when the representative agent can allocate across equity portfolios formed on the basis of characteristics like size and book-tomarket and portfolio cash flows are predictable. The state space is discrete and price-consumption ratios are obtained portfolio by portfolio simply by inverting an economy-wide matrix and multiplying this matrix by a portfolio-specific vector. The economy-wide matrix has the dimensionality of the state space. The paper calibrates cash flow predictability to the data using the consumption-wealth fraction (cay) of Lettau and Ludvigson (2000a) and dividend yield (div) as state variables. Annual cash flow processes are calibrated for three stock portfolios and for the aggregate consumption stream. The economy s representative agent possesses a relative risk aversion coefficient of either 5 or 10.