Liquidity Regimes and Optimal Dynamic Asset Allocation
69 Pages Posted: 15 Jan 2018 Last revised: 26 Oct 2018
Date Written: October 10, 2018
We solve a portfolio choice problem when expected returns, volatilities and trading-costs follow a regime-switching model. The optimal policy trades towards an aim portfolio given by a weighted-average of the conditional mean-variance portfolios in all future states. The trading speed is higher in more persistent, riskier and higher-liquidity states. It can be optimal to overweight low Sharpe-ratio assets such as Treasury bonds because they remain liquid even in crisis states. We illustrate our methodology by constructing an optimal US equity market timing portfolio based on an estimated regime-switching model and on trading costs estimated using a large-order institutional trading dataset.
Keywords: Asset Allocation, Dynamic Trading, Stochastic Transaction Costs
JEL Classification: G11
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