Precautionary saving and portfolio allocation: DP by GMM

There is much research on consumption-savings problems with risky labor inc ome and a constant interest rate and also on portfolio allocation with risk y returns but nonstochastic labor income. Less is known quantitatively abou t the interaction between the two forms of risk. Under CRRA utility, undive rsiflable income risk should be reflected in both savings rates and portfol io allocations. To quantify these effects in a model of consumption and por tfolio choice, we adopt a semi-parametric projection method for solving dyn amic programmes, based on generalized method of moments estimation of the p arameters of approximate decision rules. We find that background income ris k does affect optimal portfolios but that this effect may be difficult to d etect empirically. (C) 2001 Elsevier Science B.V. All rights reserved.