| The essays address questions in individual portfolio allocation. Chapter 1, written with Stephen Shore, examines external habit formation preferences as an explanation for equity home bias, the observed lack of international diversification in equity portfolios. Agents' utility depends on the difference between consumption and external habit, a backward-looking moving average of national aggregate consumption. If a small group of agents holds primarily domestic securities and remaining agents have external habit formation utility, then the latter will mimic the domestic bias of the smaller group. Calibration using consumption and asset return moments from several countries shows that this effect can explain large aggregate holdings of domestic assets. The model performs especially well in explaining high equity home bias in small countries.; Chapter 2 was written with John Y. Campbell and Luis Viceira. Conventional wisdom holds that conservative investors who hold foreign equities should hedge these positions and should hold only domestic Treasury bills. Domestic bills, however, are risky for long-term investors because real interest rates vary over time and bills must be rolled over at uncertain future interest rates. This risk can be hedged by holding foreign currency if the domestic currency tends to depreciate when the domestic real interest rate falls, as implied by the theory of uncovered interest parity. Empirically this effect is important and can lead conservative long-term investors to hold more than half their wealth in foreign currency.; Chapter 3 contributes methodologically to the analysis of portfolio choice problems in complete markets. Numerical techniques for deriving the choice rule in dynamic portfolio optimization typically approximate an investor's optimized utility or wealth function as an intermediate step. This intermediate step is problematic, as the choice rule then depends on derivatives of these approximated functions, which are poorly behaved. The paper, using techniques from Malliavin calculus, derives a backward induction relation that operates directly on the portfolio choice rule. This characterization allows a description of the portfolio choice rule as a solution to a quasi-linear partial differential equation (PDE) which permits direct approximation of the portfolio choice rule. |
