How Important Is Intertemporal Risk for Asset Allocation?*

Several authors have investigated whether the weak relation between equity market returns and market volatility is due to the omission of risk factors that link variations of the investment opportunity to changes in economic conditions. It has been well known since Merton (1971, 1973) that, when investment opportunities are time varying, dynamic hedging is necessary for forward-looking investors. The literature of active portfolio management is based almost exclusively on the traditional mean-variance analysis, and therefore the impact of dynamic hedging is not considered. Scruggs (1998) investigates the link between the equity market returns and long-term interest rates.