Person:

Viceira, Luis

Conventional wisdom holds that conservative investors should avoid exposure to foreign currency risk. Even if they hold foreign equities, they should hedge the currency exposure of these positions and hold only domestic Treasury bills. This paper argues that the conventional wisdom may be wrong for long-term investors. Domestic bills 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. Empirically this effect is important and can lead conservative long-term investors to hold more than half their wealth in foreign currency.

This paper derives an approximate solution to a continuous-time intertemporal portfolio and consumption choice problem. The problem is the continuous-time equivalent of the discrete-time problem studied by Campbell and Viceira (Q. J. Econ. 114 (1999) 433) in which the expected excess return on a risky asset follows an AR(1) process, while the riskless interest rate is constant. The paper also shows how to obtain continuous-time parameters that are consistent with discrete-time econometric estimates. The continuous-time solution is the limit of that of Campbell and Viceira and has the property that conservative long-term investors have a large positive intertemporal hedging demand for stocks.

We develop an approximate solution method for the optimal consumption and portfolio choice problem of an infinitely long-lived investor with Epstein–Zin utility who faces a set of asset returns described by a vector autoregression in returns and state variables. Empirical estimates in long-run annual and post-war quarterly U.S. data suggest that the predictability of stock returns greatly increases the optimal demand for stocks. The role of nominal bonds in long-term portfolios depends on the importance of real interest rate risk relative to other sources of risk. Long-term inflation-indexed bonds greatly increase the utility of conservative investors.