Long Horizons, High Risk-Aversion, and Endogenous Spreads

27 Pages Posted: 5 Oct 2011 Last revised: 1 Feb 2013

See all articles by Paolo Guasoni

Paolo Guasoni

Boston University - Department of Mathematics and Statistics; Dublin City University - School of Mathematical Sciences

Johannes Muhle-Karbe

Carnegie Mellon University - Department of Mathematical Sciences

Multiple version iconThere are 2 versions of this paper

Date Written: October 5, 2011

Abstract

For an investor with constant absolute risk aversion and a long horizon, who trades in a market with constant investment opportunities and small proportional transaction costs, we obtain explicitly the optimal investment policy, its implied welfare, liquidity premium, and trading volume. We identify these quantities as the limits of their isoelastic counterparts for high levels of risk aversion. The results are robust with respect to finite horizons, and extend to multiple uncorrelated risky assets. In this setting, we study a Stackelberg equilibrium, led by a risk-neutral, monopolistic market maker who sets the spread as to maximize profits. The resulting endogenous spread depends on investment opportunities only, and is of the order of a few percentage points for realistic parameter values.

Keywords: transaction costs, long-run, portfolio choice, exponential utility, trading volume

JEL Classification: G11, G12

Suggested Citation

Guasoni, Paolo and Muhle-Karbe, Johannes, Long Horizons, High Risk-Aversion, and Endogenous Spreads (October 5, 2011). Boston U. School of Management Research Paper No. 2011-18. Available at SSRN: https://ssrn.com/abstract=1939049 or http://dx.doi.org/10.2139/ssrn.1939049

Paolo Guasoni (Contact Author)

Boston University - Department of Mathematics and Statistics ( email )

Boston, MA 02215
United States

Dublin City University - School of Mathematical Sciences ( email )

Dublin
Ireland

HOME PAGE: http://www.guasoni.com

Johannes Muhle-Karbe

Carnegie Mellon University - Department of Mathematical Sciences ( email )

Pittsburgh, PA 15213-3890
United States

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