Portfolio Selection with Transaction Costs and Jump-Diffusion Asset Dynamics II: Economic Implications

Abstract

We derive allocation rules under isoelastic utility for a mixed jump-diffusion process in a two-asset portfolio selection problem with finite horizon in the presence of proportional transaction costs; we allow cash dividends on the risky asset. The allocation shifts toward the riskless asset relative to diffusion in varying degrees depending on parameter values. It is sensitive to the proportion of the jump component to total volatility, but also to the expected amplitude for a given proportion. The shift becomes small when the relative risk aversion increases, but it becomes major when the solvency constraint is active in the presence of jumps. We derive utility losses and risk premia due to jumps under realistic parameter values and show that even when the no transaction region is very similar between pure diffusion and the mixed process the latter corresponds to lower utility because of higher portfolio restructuring costs.

Keywords: Transaction Costs, Portfolio Selection, Jump Diffusion, Asset Allocation, Finite Horizon

JEL Classification: G10, G11