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Hedge or Rebalance: Optimal Risk Management with Transaction Costs

Author

Listed:
  • Florent Gallien

    (Swissquote Bank)

  • Serge Kassibrakis

    (Swissquote Bank)

  • Semyon Malamud

    (Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute)

Abstract

We solve the problem of optimal risk management for an investor holding an illiquid, alpha generating fund and hedging his position with a liquid futures contract. When the investor is subject to a drawdown constraint, he is forced to reduce the total risk of his portfolio after a drawdown. In this case, he faces a tradeoff of either paying the transaction costs and deleveraging, or keeping his current position in the illiquid instrument and hedging away some of the risk while keeping the residual, unhedgeable risk on his 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," Swiss Finance Institute Research Paper Series 18-60, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1860
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    More about this item

    Keywords

    Optimal Portfolio Choice; Transaction Costs; Hedging; Drawdown Constraints;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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