DP3144 Macroeconomic Influences on Optimal Asset Allocation

Author(s): Thomas Flavin, Michael R. Wickens
Publication Date: January 2002
Keyword(s): asset allocation, macroeconomic effects, multivariate GARCH
JEL(s): G11
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3144

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 an 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 the 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.