Portfolio Choice in an Incomplete Market with Frictions
Posted: 23 Aug 2010 Last revised: 10 Nov 2011
Date Written: August 23, 2010
A novel method to analyze the impact of transaction costs on a dynamically optimized portfolio is developed. Transaction costs, when taken into account in an incomplete market, generate a liquidity premium which is large enough to address important economic questions, such as the size of the equity risk premium. The sensitivity of the investor to deviations from the optimal portfolio allocation with respect to risk aversion, increases in risk aversion. This contrasts results in traditional literature, which find it to be constant, and is due to the impact of transaction costs.
Keywords: Transaction costs, Portfolio choice, incomplete market, liquidity premium, equity premium
JEL Classification: C02, G11
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