ASSET ALLOCATION WITH TIME-VARIATION IN EXPECTED RETURNS

This paper analyzes the consumption investment problem of a risk avers e investor in continuous time when there are several asset classes. Th e classic paper in this area is due to Merton who solved the problem w hen the returns were assumed to be stationary. We assume that there is time variation in the expected returns on the different assets and th at this time variation arises from movements in the underlying state v ariables. We formulate the investor's decision as a problem in optimal stochastic control. Our work extends the paper by Brennan et al. (199 7) to incorporate a different interest rate process. In addition we in vestigate the impact of transaction costs on the stock. We employ a vi scosity solution approach to the problem and to guarantee a solution w e need to impose strong assumptions.