Macroeconomic Influences on Optimal Asset Allocation

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JournalReview of Financial Economics
DatePublished - 2002
Issue number2
Volume12
Number of pages24
Pages (from-to)207-231
Original languageEnglish

Abstract

We develop a tactical asset allocation strategy that incorporates the effects of macroeconomic variables. The joint distribution of financial asset returns and the macroeconomic variables is modelled using a VAR with a multivariate GARCH (M-GARCH) error structure. As a result, the portfolio frontier is time varying and subject to contagion from the macroeconomic variable. Optimal asset allocation requires that this be taken into account. We illustrate how to do this using three risky UK assets and inflation as a macroeconomic factor. Taking account of inflation generates portfolio frontiers that lie closer to the origin and offers investors superior risk–return combinations.

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