Portfolio dynamics under illiquidity
Abstract
Purpose
This paper aims to explore the effects of illiquidity on portfolio weight and return dynamics.
Design/methodology/approach
Using a novel continuous-time framework, the paper makes two key contributions to the literature on asset pricing and illiquidity. The first is to study the effects of illiquidity on portfolio weight dynamics. The second contribution is to analyze how illiquidity affects the risk/return dynamics of a portfolio.
Findings
The numerical results highlight that investors should be prepared for potentially large and skewed variations in portfolio weights and can be away from optimal diversification for a long time when adding illiquid assets to a portfolio. Additionally, the paper shows that illiquidity increases portfolio risk. Interestingly, this effect gets more pronounced when the return correlation between the illiquid and liquid asset is low. Thus, there is a correlation effect in the sense that illiquidity costs, as measured by the increase in overall portfolio risk, are inversely related to the return correlation of the assets.
Originality/value
This is the first paper that highlights that the increase in portfolio risk caused by illiquidity is inversely related to the return correlation between the liquid and illiquid assets. This important economic result contrasts with the widely used argument that the benefit of adding illiquid (alternative) assets to a portfolio is their low correlation with (traditional) traded assets. The results imply that the benefits of adding illiquid assets to a portfolio can be much lower than typically perceived.
Keywords
Acknowledgements
The author would like to thank Simon Benninga, Scott Cederburg, Björn Eraker, Christoph Kaserer, Christian Schlag, Niklas Wagner and two anonymous referees for helpful comments and discussions. Earlier versions of the paper have also benefited from comments by participants at the International Conference Operations Research, the Annual Meeting of the Midwest Finance Association, the 12th Symposium on Finance, Banking and Insurance, the CEQURA Conference on Advances in Financial and Insurance Risk Management and the HVB-Unicredit Seminar.
Citation
Buchner, A. (2016), "Portfolio dynamics under illiquidity", Journal of Risk Finance, Vol. 17 No. 4, pp. 405-427. https://doi.org/10.1108/JRF-01-2016-0002
Publisher
:Emerald Group Publishing Limited
Copyright © 2016, Emerald Group Publishing Limited