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Dynamic asset allocation and latent variables

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We derive an explicit solution to the portfolio problem of a power utility investorwith preferences for wealth at a ¯nite investment horizon. The investor can investin assets with return dynamics described as part of a general multivariate model.The modeling framework encompasses discrete-time VAR-models where some ofthe state-variables (e.g. expected excess returns) may not be directly observable.A realistic multivariate model is estimated and applied to analyze the portfolioimplications of investment horizon and return predictability when real interest ratesand expected excess returns on stock and bonds are not directly observed but mustbe estimated as part of the problem faced by the investor. The solution exhibitssmall variability in portfolio allocations over time compared to the case when excessreturns are assumed observable.JEL Classification: G11Keywords: Portfolio choice, predictability, VAR, unobserved state-variables, hedging demands

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Carsten Sørensen, Anders Bjerre Trolle

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