IDEAS home Printed from https://ideas.repec.org/a/eee/jfinec/v136y2020i2p379-406.html
   My bibliography  Save this article

Liquidity regimes and optimal dynamic asset allocation

Author

Listed:
  • Collin-Dufresne, Pierre
  • Daniel, Kent
  • Sağlam, Mehmet

Abstract

We solve a portfolio choice problem when expected returns, covariances, and trading costs follow a regime-switching model. The optimal policy trades towards an aim portfolio given by a weighted-average of the conditional mean-variance-efficient portfolios in all future states. The trading speed is higher in more persistent, riskier, and higher-liquidity states. It can be optimal to overweight low Sharpe-ratio assets such as Treasury bonds because they remain liquid even in crisis states. We illustrate our methodology by constructing an optimal US equity market timing portfolio based on an estimated regime-switching model and on trading costs estimated using a large-order institutional trading data set.

Suggested Citation

  • Collin-Dufresne, Pierre & Daniel, Kent & Sağlam, Mehmet, 2020. "Liquidity regimes and optimal dynamic asset allocation," Journal of Financial Economics, Elsevier, vol. 136(2), pages 379-406.
    • Handle: RePEc:eee:jfinec:v:136:y:2020:i:2:p:379-406
    DOI: 10.1016/j.jfineco.2019.09.011
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0304405X19302302
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jfineco.2019.09.011?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Andrew Ang & Geert Bekaert, 2002. "International Asset Allocation With Regime Shifts," The Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1137-1187.
    2. Brennan, Michael J. & Schwartz, Eduardo S. & Lagnado, Ronald, 1997. "Strategic asset allocation," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1377-1403, June.
    3. Balduzzi, Pierluigi & Lynch, Anthony W., 1999. "Transaction costs and predictability: some utility cost calculations," Journal of Financial Economics, Elsevier, vol. 52(1), pages 47-78, April.
    4. Lynch, Anthony W. & Tan, Sinan, 2010. "Multiple Risky Assets, Transaction Costs, and Return Predictability: Allocation Rules and Implications for U.S. Investors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(4), pages 1015-1053, August.
    5. Xavier Vives, 2011. "Strategic Supply Function Competition With Private Information," Econometrica, Econometric Society, vol. 79(6), pages 1919-1966, November.
    6. Marzena Rostek & Marek Weretka, 2012. "Price Inference in Small Markets," Econometrica, Econometric Society, vol. 80(2), pages 687-711, March.
    7. Andrew Ang & Allan Timmermann, 2012. "Regime Changes and Financial Markets," Annual Review of Financial Economics, Annual Reviews, vol. 4(1), pages 313-337, October.
    8. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
    9. Kim, Tong Suk & Omberg, Edward, 1996. "Dynamic Nonmyopic Portfolio Behavior," The Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 141-161.
    10. Stoll, Hans R, 1978. "The Supply of Dealer Services in Securities Markets," Journal of Finance, American Finance Association, vol. 33(4), pages 1133-1151, September.
    11. Merton, Robert C., 1980. "On estimating the expected return on the market : An exploratory investigation," Journal of Financial Economics, Elsevier, vol. 8(4), pages 323-361, December.
    12. John Y. Campbell & Yeung Lewis Chanb & M. Viceira, 2013. "A multivariate model of strategic asset allocation," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part II, chapter 39, pages 809-848, World Scientific Publishing Co. Pte. Ltd..
    13. Massimo Guidolin & Allan Timmermann, 2006. "An econometric model of nonlinear dynamics in the joint distribution of stock and bond returns," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 21(1), pages 1-22, January.
    14. M. H. A. Davis & A. R. Norman, 1990. "Portfolio Selection with Transaction Costs," Mathematics of Operations Research, INFORMS, vol. 15(4), pages 676-713, November.
    15. Dumas, Bernard & Luciano, Elisa, 1991. "An Exact Solution to a Dynamic Portfolio Choice Problem under Transactions Costs," Journal of Finance, American Finance Association, vol. 46(2), pages 577-595, June.
    16. George M. Constantinides, 2005. "Capital Market Equilibrium with Transaction Costs," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 7, pages 207-227, World Scientific Publishing Co. Pte. Ltd..
    17. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-257, August.
    18. Bong‐Gyu Jang & Hyeng Keun Koo & Hong Liu & Mark Loewenstein, 2007. "Liquidity Premia and Transaction Costs," Journal of Finance, American Finance Association, vol. 62(5), pages 2329-2366, October.
    19. Hamilton, James D. & Susmel, Raul, 1994. "Autoregressive conditional heteroskedasticity and changes in regime," Journal of Econometrics, Elsevier, vol. 64(1-2), pages 307-333.
    20. Alan Moreira & Tyler Muir, 2017. "Volatility-Managed Portfolios," Journal of Finance, American Finance Association, vol. 72(4), pages 1611-1644, August.
    21. Foster, F Douglas & Viswanathan, S, 1993. "Variations in Trading Volume, Return Volatility, and Trading Costs: Evidence on Recent Price Formation Models," Journal of Finance, American Finance Association, vol. 48(1), pages 187-211, March.
    22. Nicolae Gârleanu & Lasse Heje Pedersen, 2013. "Dynamic Trading with Predictable Returns and Transaction Costs," Journal of Finance, American Finance Association, vol. 68(6), pages 2309-2340, December.
    23. Anthony W. Lynch & Pierluigi Balduzzi, 2000. "Predictability and Transaction Costs: The Impact on Rebalancing Rules and Behavior," Journal of Finance, American Finance Association, vol. 55(5), pages 2285-2309, October.
    24. Mei, Xiaoling & DeMiguel, Victor & Nogales, Francisco J., 2016. "Multiperiod portfolio optimization with multiple risky assets and general transaction costs," Journal of Banking & Finance, Elsevier, vol. 69(C), pages 108-120.
    25. Songzi Du & Haoxiang Zhu, 2017. "What is the Optimal Trading Frequency in Financial Markets?," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 84(4), pages 1606-1651.
    26. Jérome Detemple & Marcel Rindisbacher, 2010. "Dynamic Asset Allocation: Portfolio Decomposition Formula and Applications," The Review of Financial Studies, Society for Financial Studies, vol. 23(1), pages 25-100, January.
    27. David B. Brown & James E. Smith, 2011. "Dynamic Portfolio Optimization with Transaction Costs: Heuristics and Dual Bounds," Management Science, INFORMS, vol. 57(10), pages 1752-1770, October.
    28. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    29. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942.
    30. Barr Rosenberg., 1972. "The Behavior of Random Variables with Nonstationary Variance and the Distribution of Security Prices," Research Program in Finance Working Papers 11, University of California at Berkeley.
    31. Lynch, Anthony W. & Tan, Sinan, 2011. "Labor income dynamics at business-cycle frequencies: Implications for portfolio choice," Journal of Financial Economics, Elsevier, vol. 101(2), pages 333-359, August.
    32. Longstaff, Francis A, 2001. "Optimal Portfolio Choice and the Valuation of Illiquid Securities," The Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 407-431.
    33. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, April.
    34. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," The Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
    35. Kim, Chang-Jin, 1994. "Dynamic linear models with Markov-switching," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 1-22.
    36. Jun Liu, 2007. "Portfolio Selection in Stochastic Environments," The Review of Financial Studies, Society for Financial Studies, vol. 20(1), pages 1-39, January.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Yan, Tingjin & Han, Jinhui & Ma, Guiyuan & Siu, Chi Chung, 2023. "Dynamic asset-liability management with frictions," Insurance: Mathematics and Economics, Elsevier, vol. 111(C), pages 57-83.
    2. Ma, Guiyuan & Siu, Chi Chung & Zhu, Song-Ping, 2022. "Portfolio choice with return predictability and small trading frictions," Economic Modelling, Elsevier, vol. 111(C).
    3. Bryan Kelly & Semyon Malamud & Lasse Heje Pedersen, 2023. "Principal Portfolios," Journal of Finance, American Finance Association, vol. 78(1), pages 347-387, February.
    4. Acharya, Viral V. & Pedersen, Lasse Heje, 2019. "Economics with Market Liquidity Risk," Critical Finance Review, now publishers, vol. 8(1-2), pages 111-125, December.
    5. Hematizadeh, Roksana & Tajaddini, Reza & Hallahan, Terrence, 2022. "Dynamic asset allocation strategy using a state-dependent Markov model: Applications to international equity markets," Journal of International Money and Finance, Elsevier, vol. 128(C).
    6. Alain Bensoussan & Guiyuan Ma & Chi Chung Siu & Sheung Chi Phillip Yam, 2022. "Dynamic mean–variance problem with frictions," Finance and Stochastics, Springer, vol. 26(2), pages 267-300, April.
    7. Carré, Sylvain & Collin-Dufresne, Pierre & Gabriel, Franck, 2022. "Insider trading with penalties," Journal of Economic Theory, Elsevier, vol. 203(C).
    8. Jia Yue & Ming-Hui Wang & Nan-Jing Huang, 2022. "Global Optimal Consumption–Portfolio Rules with Myopic Preferences and Loss Aversion," Computational Economics, Springer;Society for Computational Economics, vol. 60(4), pages 1427-1455, December.
    9. Alessandro Micheli & Johannes Muhle-Karbe & Eyal Neuman, 2021. "Closed-Loop Nash Competition for Liquidity," Papers 2112.02961, arXiv.org, revised Jun 2023.
    10. Johannes Muhle-Karbe & Xiaofei Shi & Chen Yang, 2020. "An Equilibrium Model for the Cross-Section of Liquidity Premia," Papers 2011.13625, arXiv.org.
    11. Lukas Gonon & Johannes Muhle‐Karbe & Xiaofei Shi, 2021. "Asset pricing with general transaction costs: Theory and numerics," Mathematical Finance, Wiley Blackwell, vol. 31(2), pages 595-648, April.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Yao, Haixiang & Li, Danping & Wu, Huiling, 2022. "Dynamic trading with uncertain exit time and transaction costs in a general Markov market," International Review of Financial Analysis, Elsevier, vol. 84(C).
    2. Ma, Guiyuan & Siu, Chi Chung & Zhu, Song-Ping, 2020. "Optimal investment and consumption with return predictability and execution costs," Economic Modelling, Elsevier, vol. 88(C), pages 408-419.
    3. Jan Kallsen & Johannes Muhle-Karbe, 2013. "The General Structure of Optimal Investment and Consumption with Small Transaction Costs," Papers 1303.3148, arXiv.org, revised May 2015.
    4. Ma, Guiyuan & Siu, Chi Chung & Zhu, Song-Ping, 2019. "Dynamic portfolio choice with return predictability and transaction costs," European Journal of Operational Research, Elsevier, vol. 278(3), pages 976-988.
    5. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1289-1361, Elsevier.
    6. Ma, Guiyuan & Siu, Chi Chung & Zhu, Song-Ping, 2022. "Portfolio choice with return predictability and small trading frictions," Economic Modelling, Elsevier, vol. 111(C).
    7. Rapach, David E. & Wohar, Mark E., 2009. "Multi-period portfolio choice and the intertemporal hedging demands for stocks and bonds: International evidence," Journal of International Money and Finance, Elsevier, vol. 28(3), pages 427-453, April.
    8. Johannes Muhle-Karbe & Max Reppen & H. Mete Soner, 2016. "A Primer on Portfolio Choice with Small Transaction Costs," Papers 1612.01302, arXiv.org, revised May 2017.
    9. George Chacko & Luis M. Viceira, 2005. "Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets," The Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1369-1402.
    10. Anna Battauz & Alessandro Sbuelz, 2018. "Non†myopic portfolio choice with unpredictable returns: The jump†to†default case," European Financial Management, European Financial Management Association, vol. 24(2), pages 192-208, March.
    11. Rim Bernoussi & Michael Rockinger, 2023. "Rebalancing with transaction costs: theory, simulations, and actual data," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 37(2), pages 121-160, June.
    12. Mei, Xiaoling & Nogales, Francisco J., 2018. "Portfolio selection with proportional transaction costs and predictability," Journal of Banking & Finance, Elsevier, vol. 94(C), pages 131-151.
    13. Guidolin, Massimo & Hyde, Stuart, 2012. "Can VAR models capture regime shifts in asset returns? A long-horizon strategic asset allocation perspective," Journal of Banking & Finance, Elsevier, vol. 36(3), pages 695-716.
    14. Penaranda, Francisco, 2007. "Portfolio choice beyond the traditional approach," LSE Research Online Documents on Economics 24481, London School of Economics and Political Science, LSE Library.
    15. Jakub W. Jurek & Luis M. Viceira, 2011. "Optimal Value and Growth Tilts in Long-Horizon Portfolios," Review of Finance, European Finance Association, vol. 15(1), pages 29-74.
    16. Adam Farago & Erik Hjalmarsson, 2023. "Small Rebalanced Portfolios Often Beat the Market over Long Horizons," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 13(2), pages 307-342.
    17. John Y. Campbell, 2000. "Asset Pricing at the Millennium," Journal of Finance, American Finance Association, vol. 55(4), pages 1515-1567, August.
    18. Nicolae Gârleanu & Lasse Heje Pedersen, 2013. "Dynamic Trading with Predictable Returns and Transaction Costs," Journal of Finance, American Finance Association, vol. 68(6), pages 2309-2340, December.
    19. Mark E. Wohar & David E. Rapach, 2005. "Return Predictability and the Implied Intertemporal Hedging Demands for Stocks and Bonds: International Evidence," Computing in Economics and Finance 2005 329, Society for Computational Economics.
    20. Mark Broadie & Weiwei Shen, 2016. "High-Dimensional Portfolio Optimization With Transaction Costs," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(04), pages 1-49, June.

    More about this item

    Keywords

    Portfolio choice; Dynamic models; Transaction costs; Stochastic volatility; Price impact; Risk-parity; Mean-variance;
    All these keywords.

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jfinec:v:136:y:2020:i:2:p:379-406. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/505576 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.