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Portfolio Choice Under Stochastic Liquidity

2011; RELX Group (Netherlands); Linguagem: Inglês

10.2139/ssrn.1914659

1556-5068

Thomas Leirvik,

Insurance and Financial Risk Management

In this paper I develop a framework for the optimal investments in bonds when market liquidity is stochastic. The price of the investable zero-coupon bond is affected by time varying market liquidity. I find that this has several implications for the optimal investment strategies in this bond. The trading policy is found in closed form and can be decomposed into three terms. The usual mean variance term is found to be time- dependent. The investor will also hedge both interest rate risk and liquidity risk. In order to find the indirect utility function in closed form, I must reduce the dimension of the corresponding Bellmann equation. This is done through a novel transformation procedure. Hedge demands depend on risk aversion, the length of the investment period and the maturity of the bonds. I show that the investor sells short the risky bond if the liquidity is high. On the other hand, if liquidity is low then the investor is long in the bonds.