Hedge or Rebalance: Optimal Risk Management with Transaction Costs

Florent Gallien, Serge Kassibrakis and Semyon Malamud
Additional contact information
Florent Gallien: Swissquote Bank
Serge Kassibrakis: Swissquote Bank
Semyon Malamud: Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

No 18-60, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We solve the problem of optimal risk management for an investor holding an illiquid, alpha generating fund and hedging his position with a liquid futures contract. When the investor is subject to a drawdown constraint, he is forced to reduce the total risk of his portfolio after a drawdown. In this case, he faces a tradeoff of either paying the transaction costs and deleveraging, or keeping his current position in the illiquid instrument and hedging away some of the risk while keeping the residual, unhedgeable risk on his balance sheet. We explicitly characterize this tradeoff and study its dependence on asset characteristics. In particular, we show that higher alpha and lower beta typically widen the no-trading zone, while the impact of volatility is ambiguous.

Keywords: Optimal Portfolio Choice; Transaction Costs; Hedging; Drawdown Constraints (search for similar items in EconPapers)
JEL-codes: C61 G11 (search for similar items in EconPapers)
Pages: 21 pages
Date: 2018-08
New Economics Papers: this item is included in nep-ore and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1860

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