Risk sensitive asset allocation

This paper develops a continuous time modeling approach for making optimal asset allocation decisions. Macroeconomic and financial factors are explici tly modeled as Gaussian stochastic processes which directly affect the mean returns of the assets. We employ methods of risk sensitive control theory, thereby using an infinite horizon objective that is natural and features t he long run expected growth rate and the asymptotic variance as two measure s of performance, analogous to the mean return and variance, respectively, in the single period Markowitz model. The optimal strategy is a simple func tion of the factor levels, and, even with constraints on the portfolio prop ortions, it can be computed by solving a quadratic program. Explicit formul as can be obtained, as is illustrated by an example where the only factor i s a Vasicek-type interest rate and where there are two assets: cash and a s tock index. The methods are further illustrated by studies of two data sets : U.S. data with two assets and up to three factors, and Australian data wi th three assets and three factors. (C) 2000 Elsevier Science B.V. All right s reserved. JEL classification: G11; H20; C63.