Liquidity Risk Integration in Portfolio Choice: The Bid Efficient Frontier
14 Pages Posted: 22 Jan 2010 Last revised: 27 May 2010
Date Written: May 5, 2010
In this paper a tractable solution is proposed to integrate, to a certain extent, market liquidity risk in the portfolio selection process. It is shown how an investor may take advantage of this additional risk source within the standard mean-variance optimisation framework, by in certain circumstances overcoming the pitfalls of illiquidity and in others seizing a liquidity premium.
Bid prices appear effective to capture liquidity risk. The efficient frontier conceived with bid prices consists of mean-variance optimal allocations that cover more liquid stocks (large caps) under stressed market conditions and less liquid stocks (small caps) under normal conditions.
Keywords: portfolio choice, market liquidity risk, mean-variance framework, bid prices
JEL Classification: C51, D82, G11
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
By Yu Tian