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The premium of dynamic trading

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  • Chun Hung Chiu
  • Xun Yu Zhou
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    Abstract

    It is well established that, in a market with inclusion of a risk-free asset, the single-period mean-variance efficient frontier is a straight line tangent to the risky region, a fact that is the very foundation of the classical CAPM. In this paper, it is shown that, in a continuous-time market where the risky prices are described by Ito processes and the investment opportunity set is deterministic (albeit time-varying), any efficient portfolio must involve allocation to the risk-free asset at any time. As a result, the dynamic mean-variance efficient frontier, although still a straight line, is strictly above the entire risky region. This in turn suggests a positive premium, in terms of the Sharpe ratio of the efficient frontier, arising from dynamic trading. Another implication is that the inclusion of a risk-free asset boosts the Sharpe ratio of the efficient frontier, which again contrasts sharply with the single-period case.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/14697681003685589
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

    Volume (Year): 11 (2011)
    Issue (Month): 1 ()
    Pages: 115-123

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    Handle: RePEc:taf:quantf:v:11:y:2011:i:1:p:115-123

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    Related research

    Keywords: Continuous time; Portfolio selection; Mean-variance efficiency; Sharpe ratio;

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    Cited by:
    1. Di Giacinto, Marina & Federico, Salvatore & Gozzi, Fausto & Vigna, Elena, 2014. "Income drawdown option with minimum guarantee," European Journal of Operational Research, Elsevier, vol. 234(3), pages 610-624.
    2. Yao, Haixiang & Li, Zhongfei & Chen, Shumin, 2014. "Continuous-time mean–variance portfolio selection with only risky assets," Economic Modelling, Elsevier, vol. 36(C), pages 244-251.

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