Optimal Portfolio Selection with Transaction Costs and 'Event Risk'

36 Pages Posted: 5 Mar 2007

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: March 15, 2007

Abstract

Models with event risk (the possibility of sudden large price movements) have proven important for option pricing (e.g., Bates (1996))and optimal portfolio selection (e.g., Liu, Longstaff and Pan(2003)). However, most of the existing studies ignore transaction costs which are prevalent in almost all of the financial markets. How investors should trade in the presence of event risks and transaction costs remains an important but unanswered question. In this paper, we consider the optimal trading strategy for a CRRA investor who derives utility from terminal wealth and can continuously trade in a riskless asset and a risky asset. The risky asset, whose price follows a jump diffusion, is subject to proportional transaction costs. We show that the optimal trading strategy is to maintain the fraction of wealth invested in the risky asset between two bounds. In contrast to the case without jump risk, this fraction can jump outside the bounds which implies a discrete transaction back to the closest boundary and thus a greater transaction cost payment. We characterize the value function and provide bounds on the trading boundaries. Somewhat surprisingly, we find that an increase in transaction costs may increase trading frequency. Our numerical results suggest that event risk significantly reduces stock holdings and decreases trading frequency. We also show that the boundaries are affected not only by jump sizes but also by the uncertainty about jump sizes. Furthermore, we examine how the optimal transaction boundaries vary through time for investors with deterministic horizons.

Keywords: Event Risk, Portfolio Selection, Transaction Costs

JEL Classification: D11, D91, G11, C61

Suggested Citation

Liu, Hong and Loewenstein, Mark, Optimal Portfolio Selection with Transaction Costs and 'Event Risk' (March 15, 2007). AFA 2008 New Orleans Meetings Paper. Available at SSRN: https://ssrn.com/abstract=965263 or http://dx.doi.org/10.2139/ssrn.965263

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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