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On Portfolio Choice, Liquidity, and Short Selling: A Nonparametric Investigation

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  • Eric Ghysels

    ()

  • João Pereira

Abstract

This paper studies the time series effect of changes in liquidity on optimal portfolio allocations. Using a nonparametric approach, we are able to handle models that are analytically intractable. Specifically, we directly estimate optimal portfolio weights for a CRRA investor as functions of liquidity. Liquidity is measured by turnover, dollar volume, or price impact. We consider three different investment horizons: daily, weekly, and monthly. Using a sample of NYSE stocks from 1963-2000, we document a very interesting temporal dimension to the effects of changes in liquidity: whereas optimal weights are strongly increasing functions of liquidity at the very short daily and weekly horizons, they become decreasing functions of liquidity at longer monthly horizons. Overall, the dependence of optimal weights on liquidity is most noticeable for small stocks at short investment horizons. Finally, the optimal conditional portfolio weights documented in this paper are never negative, which may help explain the low level of short selling observed in the US stock market. Nous estimons des décisions de choix de portefeuille en fonction de mesures de liquidité à l'aide de méthodes non paramétriques. Nous trouvons que les parts optimales de portefeuilles sont surtout influencées par la liquidité pour des horizons à court-terme. Par ailleurs, ces parts optimales sont toujours positives, ce qui pourrait expliquer le peu de vente à découvert observé sur le marché américain.

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Bibliographic Info

Paper provided by CIRANO in its series CIRANO Working Papers with number 2003s-27.

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Date of creation: 01 May 2003
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Handle: RePEc:cir:cirwor:2003s-27

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Keywords: portfolio choice; liquidity; short-selling; choix de portefeuille; liquidité; vente à découvert;

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References

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  1. Almazan, Andres & Brown, Keith C. & Carlson, Murray & Chapman, David A., 2004. "Why constrain your mutual fund manager?," Journal of Financial Economics, Elsevier, vol. 73(2), pages 289-321, August.
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  8. LeBaron, B., 1992. "Persistence of the Dow Jones Index on Rising Volume," Working papers 9201, Wisconsin Madison - Social Systems.
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  12. Longstaff, Francis A, 2001. "Optimal Portfolio Choice and the Valuation of Illiquid Securities," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 407-31.
  13. Guillermo Llorente & Roni Michaely & Gideon Saar & Jiang Wang, 2002. "Dynamic Volume-Return Relation of Individual Stocks," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1005-1047.
  14. Geczy, Christopher C. & Musto, David K. & Reed, Adam V., 2002. "Stocks are special too: an analysis of the equity lending market," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 241-269.
  15. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
  16. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1996. "Market microstructure and asset pricing: On the compensation for illiquidity in stock returns," Journal of Financial Economics, Elsevier, vol. 41(3), pages 441-464, July.
  17. Atsushi Inoue & Mototsugu Shintani, 2001. "Bootstrapping GMM Estimators for Time Series," Vanderbilt University Department of Economics Working Papers 0129, Vanderbilt University Department of Economics, revised Aug 2003.
  18. Rajnish Mehra & Edward C. Prescott, 2003. "The Equity Premium in Retrospect," NBER Working Papers 9525, National Bureau of Economic Research, Inc.
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