Event Risks, Illiquidity, and Portfolio Selection

37 Pages Posted: 17 Dec 2009

See all articles by Hong Liu

Hong Liu

Washington University in St. Louis - Olin Business School; Fudan University - China Institute of Economics and Finance

Mark Loewenstein

University of Maryland - Robert H. Smith School of Business

Date Written: December 15, 2009

Abstract

The most recent financial crisis highlights the importance of event risks and the ensuing market illiquidity and worsening investment opportunity set for optimal portfolio selection. However, the existing portfolio selection literature does not consider the joint impact of these risks. In this paper, we develop a tractable and flexible workhorse model where market crashes can trigger switching into an illiquid regime with a possibly different investment opportunity set. We explicitly characterize the optimal trading strategy as the solution to coupled differential-integral equations with free boundaries and propose an iterative numerical solution procedure that can be applied to a more general class of problems. We conduct an extensive analysis of the optimal trading strategy before and after a market crash. In particular, our analysis quantifies when "flight-to-quality'' after a crash is optimal even if the market becomes illiquid. Interestingly, while large price movements may trigger large transactions and high transaction costs in a given regime, they might help reduce rebalancing costs across regimes.

Keywords: Crash, Illiquidity, Portfolio Selection

JEL Classification: D11, D91, G11, C61

Suggested Citation

Liu, Hong and Loewenstein, Mark, Event Risks, Illiquidity, and Portfolio Selection (December 15, 2009). Available at SSRN: https://ssrn.com/abstract=1523865 or http://dx.doi.org/10.2139/ssrn.1523865

Hong Liu (Contact Author)

Washington University in St. Louis - Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-5883 (Phone)

Fudan University - China Institute of Economics and Finance ( email )

China

Mark Loewenstein

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States

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