Optimal Investment and Consumption with Return Predictability and Execution Costs

30 Pages Posted: 2 May 2019 Last revised: 7 Oct 2019

See all articles by Guiyuan Ma

Guiyuan Ma

Xi'an Jiaotong University (XJTU) - School of Economics and Finance

Chi Chung Siu

Department of Mathematics, Statistics and Insurance, School of Decision Sciences, The Hang Seng University of Hong Kong

Song-Ping Zhu

University of Wollongong

Date Written: December 7, 2018

Abstract

We provide a closed-form solution to an optimal investment and consumption problem for a constant absolute risk aversion (CARA) agent, who faces execution costs when trading correlated risky assets with return predictability. The optimal investment strategy indicates that the agent should trade gradually toward a dynamic aim portfolio, which is an adjusted Merton portfolio with modifications to account for the persistence of the return predicting signals and the execution costs. The optimal consumption strategy is quadratic in the return predicting signals and linear in the agent’s wealth. Our numerical studies show that the execution costs diminish the importance of asset return predictability on the agent’s optimal investment strategy, thereby confirming the conjecture raised by Liu (2004). In addition, the presence of the intermediate consumption leads to a more aggressive aim portfolio than the case without consumption.

Keywords: Continuous-time investment and consumption problem; Return predictability; Linear temporary price impact; Execution costs; Utility maximization.

JEL Classification: G11, G12

Suggested Citation

Ma, Guiyuan and Siu, Chi Chung and Zhu, Song-Ping, Optimal Investment and Consumption with Return Predictability and Execution Costs (December 7, 2018). Economic Modelling, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3378330 or http://dx.doi.org/10.2139/ssrn.3378330

Guiyuan Ma (Contact Author)

Xi'an Jiaotong University (XJTU) - School of Economics and Finance ( email )

No.74, Yanta Road, Xi'an, Shaanxi, P.R. China
Xi'an, Shaanxi 710061
China

Chi Chung Siu

Department of Mathematics, Statistics and Insurance, School of Decision Sciences, The Hang Seng University of Hong Kong ( email )

Hang Shin Link
Siu Lek Yuen
Shatin, Hong Kong
China

Song-Ping Zhu

University of Wollongong ( email )

Northfield Ave.
Wollongong, NSW
Australia
61-2-42213807 (Phone)

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