NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Liquidity Regimes and Optimal Dynamic Asset Allocation

Pierre Collin-Dufresne, Kent D. Daniel, Mehmet Saǧlam

NBER Working Paper No. 24222
Issued in January 2018
NBER Program(s):Asset Pricing

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.

You may purchase this paper on-line in .pdf format from SSRN.com ($5) for electronic delivery.

Access to NBER Papers

You are eligible for a free download if you are a subscriber, a corporate associate of the NBER, a journalist, an employee of the U.S. federal government with a ".GOV" domain name, or a resident of nearly any developing country or transition economy.

If you usually get free papers at work/university but do not at home, you can either connect to your work VPN or proxy (if any) or elect to have a link to the paper emailed to your work email address below. The email address must be connected to a subscribing college, university, or other subscribing institution. Gmail and other free email addresses will not have access.

E-mail:

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w24222

Users who downloaded this paper also downloaded* these:
Freyberger, Neuhierl, and Weber w23227 Dissecting Characteristics Nonparametrically
Fleckenstein and Longstaff w24224 Shadow Funding Costs: Measuring the Cost of Balance Sheet Constraints
Lettau and Madhavan w24250 Exchange Traded Funds 101 For Economists
Berndt, Douglas, Duffie, and Ferguson w24213 Corporate Credit Risk Premia
Feenberg, Tepper, and Welch w24258 Are Interest Rates Really Low?
 
Publications
Activities
Meetings
NBER Videos
Themes
Data
People
About

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us