Liquidity Regimes and Optimal Dynamic Asset Allocation

Pierre Collin-Dufresne, Kent D. Daniel and Mehmet Sağlam
Additional contact information
Pierre Collin-Dufresne: Ecole Polytechnique Fédérale de Lausanne, Swiss Finance Institute, and National Bureau of Economic Research (NBER)
Kent D. Daniel: Columbia Business School - Finance and Economics and National Bureau of Economic Research (NBER)
Mehmet Sağlam: University of Cincinnati

No 18-43, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We solve for the optimal dynamic asset allocation when expected returns, volatilities, and trading costs follow a regime switching model. The optimal policy is to trade partially towards an aim portfolio with a given trading speed. In a given state, the aim portfolio is a weighted average of mean-variance portfolios in every state, where the weight is a function of the probability of transitioning to that state, and the state's persistence, risk and trading costs. The trading speed is higher in states that are more persistent, where return volatility is higher and trading costs are lower. It can be optimal to deviate substantially from the mean-variance efficient portfolio (or from the risk-parity allocation) and to underweight high Sharpe ratio (high volatility) assets, as well as to trade more aggressively the less liquid assets in anticipation of an increase in their volatility and trading costs. We illustrate our approach in an empirical exercise in which we exploit time-variation in the expected return, volatility, and cost of trading of the value-weighted market portfolio of US common stocks. We estimate a regime switching model applied to a dataset of institutional trades, and find that realized trading costs are significantly higher when market volatility is high. The optimal dynamic strategy significantly outperforms a myopic trading strategy in an out-of-sample experiment. The highest gains arise from timing the changes in volatility and trading costs rather than expected returns.

Keywords: Asset Allocation; Dynamic Trading; Stochastic Transaction Costs (search for similar items in EconPapers)
JEL-codes: G11 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2018-01, Revised 2018-05
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3099895 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1843

Access Statistics for this paper

More papers in Swiss Finance Institute Research Paper Series from Swiss Finance Institute Contact information at EDIRC.
Bibliographic data for series maintained by Ridima Mittal ().