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It'S 11 Pm—Do You Know Where Your Liquidity Is?: The Mean–Variance–Liquidity Frontier

In: The World Of Risk Management

Author

Listed:
  • Andrew W. Lo

    (Harris & Harris Group Professor, MIT Sloan School of Management, and Chief Scientific Officer, AlphaSimplex Group, LLC, 50 Memorial Drive, Cambridge, MA 02142-1347, USA)

  • Constantin Petrov

    (Research Analyst, Fidelity Management and Research Co., 82 Devonshire Street, Boston, MA 02109, USA)

  • Martin Wierzbicki

    (838 Green Street, San Francisco, CA 94133, USA)

Abstract

We introduce liquidity into the standard mean–variance portfolio optimization framework by defining several measures of liquidity and then constructing three-dimensional mean–variance–liquidity frontiers in three ways: liquidity filtering, liquidity constraints, and a mean–variance–liquidity objective function. We show that portfolios close to each other on the traditional mean–variance efficient frontier can differ substantially in their liquidity characteristics. In a simple empirical example, the liquidity exposure of mean–variance efficient portfolios changes dramatically from month to month, and even simple forms of liquidity optimization can yield significant benefits in reducing a portfolio's liquidity-risk exposure without sacrificing a great deal of expected return per unit risk.

Suggested Citation

  • Andrew W. Lo & Constantin Petrov & Martin Wierzbicki, 2005. "It'S 11 Pm—Do You Know Where Your Liquidity Is?: The Mean–Variance–Liquidity Frontier," World Scientific Book Chapters, in: H Gifford Fong (ed.), The World Of Risk Management, chapter 3, pages 47-92, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789812700865_0003
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