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Liquidity Regimes and Optimal Dynamic Asset Allocation

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

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

We solve a portfolio choice problem when expected returns, volatilities and trading-costs follow a regime-switching model. The optimal policy trades towards an aim portfolio given by a weighted-average of the conditional mean-variance portfolios in all future states. The trading speed is higher in more persistent, riskier and higher-liquidity states. It can be optimal to overweight low Sharpe-ratio assets such as Treasury bonds because they remain liquid even in crisis states. We illustrate our methodology by constructing an optimal US equity market timing portfolio based on an estimated regime-switching model and on trading costs estimated using a large-order institutional trading dataset.

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Document Object Identifier (DOI): 10.3386/w24222

Published: Pierre Collin-Dufresne & Kent Daniel & Mehmet Sağlam, 2019. "Liquidity regimes and optimal dynamic asset allocation," Journal of Financial Economics, .

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