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Hedge or Rebalance: Optimal Risk Management with Transaction Costs

Author

Listed:
  • Florent Gallien

    (Swissquote, Chemin de la Crétaux 33, 1196 Gland, Switzerland)

  • Serge Kassibrakis

    (Swissquote, Chemin de la Crétaux 33, 1196 Gland, Switzerland)

  • Semyon Malamud

    (Swiss Finance Institute, Boulevard du Pont-d’Arve 40, 1205 Genéve, Switzerland
    Ecole Polytechnique Fédérale de Lausanne, UNIL Dorigny, 1015 Lausanne, Switzerland
    Centre for Economic Policy Research, 33 Great Sutton St, Clerkenwell, London EC1V 0DX, UK)

Abstract

We solve the problem of optimal risk management for an investor holding an illiquid, alpha-generating fund and hedging his/her position with a liquid futures contract. When the investor is subject to a lower bound on net return, he/she is forced to reduce the total risk of his/her portfolio after a loss. In this case, he/she faces a tradeoff of either paying the transaction costs and deleveraging or keeping his/her current position in the illiquid instrument and hedging away some of the risk while keeping the residual, unhedgeable risk on his/her balance sheet. We explicitly characterize this tradeoff and study its dependence on asset characteristics. In particular, we show that higher alpha and lower beta typically widen the no-trading zone, while the impact of volatility is ambiguous.

Suggested Citation

  • Florent Gallien & Serge Kassibrakis & Semyon Malamud, 2018. "Hedge or Rebalance: Optimal Risk Management with Transaction Costs," Risks, MDPI, vol. 6(4), pages 1-14, October.
    • Handle: RePEc:gam:jrisks:v:6:y:2018:i:4:p:112-:d:174200
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    References listed on IDEAS

    as
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