Portfolio Choice with Market Closure and Implications for Liquidity Premia

Abstract

M ost existing portfolio choice models ignore the prevalent periodic market closure and the fact that market volatility is significantly higher during trading periods. We find that market closure and the volatility difference across trading and nontrading periods significantly change optimal trading strategies. In addition, we demonstrate numerically that transaction costs can have a first-order effect on liquidity premia that is largely comparable to empirical findings. Moreover, this effect on liquidity premia increases in the volatility difference, which is supported by our empirical analysis.

Incomplete Information and the Liquidity Premium Puzzle

“…However, after reasonable calibration, their result is still significantly smaller than what is documented in empirical evidence. Dai, Li, Liu, and Wang (2016) show that, if one incorporates in the model the well-established fact that market volatility during trading periods (i.e., from open to close on the same trading day) is significantly larger than the volatility during non-trading periods (from close in one day to open in the following trading day), then transaction costs have a first-order effect on liquidity premia, which is comparable to the empirical evidence.…”

“…To the best of our knowledge, there are three main references on this topic. The references are JKLL, Lynch andTan (2011), andDai, Li, Liu, andWang (2016). The common element in these three references is the idea that one should allow for time-varying investment opportunities.…”

“…To formally verify this intuition, we follow Dai, Li, Liu, and Wang (2016) when disentangling the part of the liquidity premium that is due to suboptimal risk exposure from the part due to the payment of transaction costs. We denote by δ 0 (p 0 ) the liquidity premium that is due exclusively to suboptimal risk exposure.…”

Portfolio Choice with Illiquid Assets

“…Longstaff (2001)) or at deterministic times (e.g. Kahl, Liu, and Longstaff (2003); Koren and Szeidl (2003); Schwartz and Tebaldi (2006); Longstaff (2009);De Roon, Guo, and Ter Horst (2009); Dai, Li, Liu, and Wang (2010)). In these models, trade can always be generated at a known rate simply by waiting.…”

A Primer on Portfolio Choice with Small Transaction Costs

“…Starting with the work of Constantinides and Magill [64], Constantinides [23], Dumas and Luciano [34], Davis and Norman [29], and Shreve and Soner [81], models with transaction costs have been subjected to intensive research. For example, much effort has been devoted to understanding liquidity premia in asset pricing [23,53,63,25] or how transaction costs shape the trading volume in financial markets [80,62,42]. On a more practical level, transaction costs play a crucial role in the design and implementation of trading strategies in the asset management industry, cf., e.g., [45,66,30,65].…”