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Illiquidity in portfolio rebalancing: Evidence from the German covered bond market

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  • Koziol, Christian
  • Fauß, Tobias

Abstract

This paper studies the impact of asset illiquidity on portfolio performance under rebalancing constraints. While illiquid assets can offer higher expected returns through liquidity premia, rebalancing requirements may necessitate selling these assets before their intended investment horizon at a discount. We develop a two-period, three-asset model that identifies two rebalancing risk channels: a bond channel, where early sales of the illiquid assets can cause additional losses relative to (otherwise identical but) liquid assets, and an equity channel, where simultaneous liquidity and equity shocks reduce the post-rebalancing stock exposure. In favorable markets, rebalancing enhances realized liquidity premia via both channels, while in downturns, it amplifies losses. To illustrate these effects, we use German market data from January 2004 to February 2025 for liquid government bonds, less liquid covered bonds and a stock market index.

Suggested Citation

  • Koziol, Christian & Fauß, Tobias, 2026. "Illiquidity in portfolio rebalancing: Evidence from the German covered bond market," Finance Research Letters, Elsevier, vol. 98(C).
    • Handle: RePEc:eee:finlet:v:98:y:2026:i:c:s1544612326003752
    DOI: 10.1016/j.frl.2026.109845
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