The premium of dynamic trading

Chun Hung Chiu and Xun Yu Zhou

Quantitative Finance, 2011, vol. 11, issue 1, 115-123

Abstract: It is well established that, in a market with inclusion of a risk-free asset, the single-period mean-variance efficient frontier is a straight line tangent to the risky region, a fact that is the very foundation of the classical CAPM. In this paper, it is shown that, in a continuous-time market where the risky prices are described by Ito processes and the investment opportunity set is deterministic (albeit time-varying), any efficient portfolio must involve allocation to the risk-free asset at any time. As a result, the dynamic mean-variance efficient frontier, although still a straight line, is strictly above the entire risky region. This in turn suggests a positive premium, in terms of the Sharpe ratio of the efficient frontier, arising from dynamic trading. Another implication is that the inclusion of a risk-free asset boosts the Sharpe ratio of the efficient frontier, which again contrasts sharply with the single-period case.

Keywords: Continuous time; Portfolio selection; Mean-variance efficiency; Sharpe ratio (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (6)

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DOI: 10.1080/14697681003685589

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