Liquidity Risk Integration in Portfolio Choice: The Bid Efficient Frontier

14 Pages Posted: 22 Jan 2010 Last revised: 27 May 2010

See all articles by Pierre Clauss

Pierre Clauss

Société Générale; Université d'Évry - Centre D'Etudes des Politiques Economiques et de L'Emploi (EPEE)

Date Written: May 5, 2010

Abstract

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

Clauss, Pierre, Liquidity Risk Integration in Portfolio Choice: The Bid Efficient Frontier (May 5, 2010). Available at SSRN: https://ssrn.com/abstract=1505391 or http://dx.doi.org/10.2139/ssrn.1505391

Pierre Clauss (Contact Author)

Société Générale ( email )

Université d'Évry - Centre D'Etudes des Politiques Economiques et de L'Emploi (EPEE) ( email )

Boulevard Francois Mitterrand
F-91025 Evry Cedex
France

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