Control Bands for Tracking Constant Portfolio Allocations with Fixed and Proportional Transaction Costs
AbstractThe vast majority of research related to optimal asset allocation strategies in the presence of transaction costs, requires formulation of highly sophisticated numerical schemes for the estimation of no-transaction bands; moreover, the optimization objectives examined are far less compared to the number of works that assume frictionless trading. In this article, we point out that an investor may alternatively try to track a constant allocation strategy as derived under the frictionless markets hypothesis and any optimization objective, by applying a loss function that reflects his/her risk preferences. We focus in the two-asset case (one riskless and one risky) and assume a fixed cost per transaction plus a cost proportional to the change in the risky fraction process. Using a recently proposed transformation of the risky fraction process by Nagai (2005), we derive optimal rebalancing policies for the quadratic loss case, using two alternative methods. First, we calculate no transaction bands for investors who choose the boundaries of the bands and their optimal rebalancing actions so that they minimize long run cost per unit time. The latter is defined as the expected cost per transaction cycle (opportunity cost/tracking error plus transaction cost) divided by the expected cycle time. In the second case, the objective is to minimize the expected discounted squared tracking error plus discounted transaction costs over an infinite horizon. On that purpose, similar to Suzuki and Pliska (2004), we use impulse control theory in a continuous-time, dynamic setting and characterize the optimal strategy in terms of a quasi-variational inequality. For both formulations, we derive explicit solutions, which we use to perform sensitivity analysis for the control bands with respect to the market parameters and the magnitude of the transaction costs.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by University of Crete, Department of Economics in its series Working Papers with number 0610.
Length: 32 pages
Date of creation: May 2006
Date of revision:
risky fraction process; stochastic impulse controls; control bands; quasi-variational inequalities;
Find related papers by JEL classification:
- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-10-07 (All new papers)
- NEP-FIN-2006-10-07 (Finance)
- NEP-FMK-2006-10-07 (Financial Markets)
You can help add them by filling out this form.
CitEc Project, subscribe to its RSS feed for this item.
- Yiannis Kamarianakis & Anastasios Xepapadeas, 2006. "Stochastic impulse control with discounted and ergodic optimization criteria: A comparative study for the control of risky holdings," Working Papers 0709, University of Crete, Department of Economics.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Kostis Pigounakis).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.