Dynamic Consumption With Labor Income - Portfolio Selection Theory And Application

With the wealth accumulation and the development of financial market, people are eagerly expecting to improve the living quality which creates the demand for financial advice. Dynamic consumption and portfolio choice theory provides the investors a wonderful framework for making decision.Since the seminal work of Samuelson (1969) and Merton (1969, 1971), hundreds of publications are printed, especially for the case of no stochastic intertemporal endowment. Here this dissertation will focus on the optimal dynamic consumption and portfolio choice with stochastic intertemporal endowment - labor income. To investors, the whole wealth they have is not only the wealth on the book, but also a important and nontradable asset - Human Resource - which can be simply regarded as the expect discount value of future labor income flow.After a review of publications about dynamic asset allocation, we begin with the hedgeable labor income case. Firstly, based on the result of Liu (2006), we derive the explicit solution for optimal portfolio choice with power utility. Secondly, in the framework of complete market, the implication of bond in asset allocation is discussed. We find, as a investment opportunity hedging instruments, bonds are allocated to match the certain equivalence cash flow of optimal consumption. This process is just a general duration hedging, which is consistent with financial industry advice. This certain equivalence cash flow can be defined in a new equivalent martingale measure. Thirdly, with the general solution we get before, we analyze the optimal allocation under 2 factor interest rate setting. The 2 factor setting helps us figure out the different usage of short term bond and long term bond. The main demand for long term bond is from the risk matching/duration matching of long term investors. In a 2 factor structure, though 2 bonds are required to complete the financial market, investors can realize the hedging with 1 specific bond under some circumstance. When the long term bonds are not available, investors need to take leveraged position to hedge the investment opportunity risk. With the limit of leveraged position, investors can't achieve the optimal utility. In a word, long term bond is a terrific instrument for long term investors.In next part, the questions in incomplete market are discussed. Firstly, we present the effect of borrowing constraint. Based on the explicit solution we derived, we find, for investors with poor perspective of future income, their conservative policies will ensure the nonbinding of borrowing constraint. For others, with the increasing of wealth, the effect of borrowing constraint is decreasing. When certain threshold is reached, there's no effect of borrowing constraint. Then we turn to the problem with unhedgeable labor income. We find, the optimal consumption is not clearly related to the hedgeable risk and unhedgeable risk which is different with precautious saving theory in macroeconomics. Due to the unavailability of explicit solution in this case, we present an approximate solution and a numerical algorithm. At last, we analyze the household savings in China under the framework and numerical solution we presented before. We find, the high household savings in China is explained by the dynamic asset allocation theory. The difference between optimal saving rate and realized saving rate is fairly small. Furthermore, the structural factors in the theoretical model, such as wealth level, structure of investment horizon and characteristics of labor income, have implications on solving high household savings in China.