Hedge or Rebalance: Optimal Risk Management with Transaction Costs

Florent Gallien, Serge Kassibrakis and Semyon Malamud
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Florent Gallien: Swissquote, Chemin de la Crétaux 33, 1196 Gland, Switzerland
Serge Kassibrakis: Swissquote, Chemin de la Crétaux 33, 1196 Gland, Switzerland
Semyon Malamud: Swiss Finance Institute, Boulevard du Pont-d’Arve 40, 1205 Genéve, Switzerland

Risks, 2018, vol. 6, issue 4, 1-14

Abstract: We solve the problem of optimal risk management for an investor holding an illiquid, alpha-generating fund and hedging his/her position with a liquid futures contract. When the investor is subject to a lower bound on net return, he/she is forced to reduce the total risk of his/her portfolio after a loss. In this case, he/she faces a tradeoff of either paying the transaction costs and deleveraging or keeping his/her current position in the illiquid instrument and hedging away some of the risk while keeping the residual, unhedgeable risk on his/her 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 (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2018
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