Portfolio choice with stochastic interest rates and learning about stock return predictability

- We analyze bond portfolio when stock returns are predictable and unobservable.
- Stock return predictability can significantly impact the bond portfolio.
- Bonds can be useful in learning about the unobserved stock predictors.
- Bonds might play a big role in hedging stock return predictors.
- Stochastic volatility of the stock can be used as an observed predictor.

We analyze how investors should optimally choose to invest under the assumptions that interest rates are stochastic and stock returns are predictable with observed and unobserved factors. The stock risk premium is taken to be an affine function of the predictive variables and the stock return volatility is assumed to depend on the observed factor. The latent factor is estimated based on the observations. It is shown that stock return predictability can significantly impact the optimal bond portfolio. Considerable welfare benefits may arise from using bonds in learning about/hedging against stock return predictors.