Liquidity Risk Integration in Portfolio Choice: The Bid Efficient Frontier

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