Asset Pricing.

Members and guests of the NBER's Program on Asset Pricing met in Chicago on November 5. Program Director John H. Cochrane of the University of Chicago chose the following papers for discussion:

George Chacko, Harvard University, and Luis M. Viceira, NBER and Harvard University, "Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets" (NBER Working Paper No. 7377)

Discussant: Michael W. Brandt, NBER and University of Pennsylvania

Anthony W. Lynch, New York University, "Portfolio Choice and Equity Characteristics: Characterizing the Hedging Demands Induced by Return Predictability"

Discussant: Jessica Wachter, Harvard University

Gregory R. Duffee, University of California, Berkeley, "Forecasting Future Interest Rates: Are Affine Models Failures?"

Discussant: Michael Johannes, University of Chicago

Owen Lamont, NBER and University of Chicago, and Christopher Polk, Northwestern University, "The Diversification Discount: Cash Flows versus Returns" (NBER Working Paper No. 7396)

Discussant: Narasimhan Jegadeesh, University of Illinois

Martin Lettau and Sydney C. Ludvigson, Federal Reserve Bank of New York, "A Cross-Sectional Test of Linear Factor Models with Time-Varying Risk Premiums"

Discussant: Ravi Jagannathan, NBER and Northwestern University

Nicholas Barberis, NBER and University of Chicago; Ming Huang, Stanford University; and Tano Santos, University of Chicago, "Prospect Theory and Asset Prices" (NBER Working Paper No. 7220)

Discussant: Kent D. Daniel, NBER and Northwestern University

Chacko and Viceira ask what the optimal savings and portfolio allocations are for long-horizon investors when the variation in stock return volatility is predictable. They find that the optimal portfolio demand for stocks varies with investors' risk aversion, but only slightly with their willingness to substitute consumption for investment. By contrast, the optimal level of savings relative to wealth depends on both risk aversion and willingness to substitute consumption for saving. For long-horizon, risk-averse investors it is optimal to reduce portfolio holdings of stocks when changes in return volatility are negatively correlated with excess stock returns. This helps investors to hedge their exposure to volatility risk. The magnitude of the reduction in portfolio demand increases with the size of the correlation and, more importantly, with the persistence of changes in volatility. For the U.S. stock market, the...