Portfolio Choice with Illiquid Assets

Abstract:     
We solve for optimal asset allocation and consumption policies for long-lived constant relative risk averse (CRRA) investors holding both liquid and illiquid assets. Liquid assets can be rebalanced continuously, whereas illiquid assets can only be traded at infrequent, stochastic intervals. By creating an unhedgeable source of risk, illiquidity induces additional time-varying risk aversion above the constant utility coefficient of risk aversion. Illiquidity risk affects the asset allocation of both liquid and illiquid securities and causes optimal consumption and portfolio policies to depend on the mix of illiquid and liquid assets in the investor’s portfolio. Illiquidity effects are observed even for log utility investors and when liquid and illiquid asset returns are uncorrelated.

Number of Pages in PDF File: 50

Keywords: asset allocation, liquidity, alternative assets, endowment model

JEL Classification: G11, G12

working papers series