Robust consumption and portfolio choice with derivatives trading

This paper analyzes the optimal consumption and portfolio choice problem for an ambiguity-averse in-vestor with recursive preferences. The investor has access to both the stock and derivatives markets. The stock price process follows a stochastic volatility jump-diffusion model and the investor can have dif-ferent levels of ambiguity about diffusion and jump risks, respectively. We obtain an exact analytical solution for investors with unit elasticity of intertemporal substitution of consumption and an approx-imate solution otherwise. We find that the optimal consumption policy is more sensitive to ambiguity aversion with respect to diffusion risks than the jump risk. The optimal exposures to diffusion and jump risks are significantly affected by the corresponding ambiguity aversions in the complete market; how-ever, the optimal stock investment is relatively insensitive to jump misspecification in the incomplete market. We also show that taking into consideration ambiguity aversion to diffusion risks and participat-ing in the derivatives market are essential to reduce the potential welfare loss, while the impact of jump misspecification is marginal.(c) 2022 Elsevier B.V. All rights reserved.

Automated summary

This paper examines the optimal consumption and portfolio choice problem for ambiguity-averse investors with recursive preferences. The findings suggest that the optimal consumption strategy is more sensitive to ambiguity aversion towards diffusion risks than jump risks. Participating in the derivatives market and considering the ambiguity aversion towards diffusion risks are essential in reducing potential welfare loss, while the impact of jump misspecification is marginal.