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Illiquidity, position limits, and optimal investment for mutual funds

  • Dai, Min
  • Jin, Hanqing
  • Liu, Hong
Registered author(s):

We study the optimal trading strategy of mutual funds that face both position limits and differential illiquidity. We provide explicit characterization of the optimal trading strategy and conduct an extensive analytical and numerical analysis of the optimal trading strategy. We show that the optimal trading boundaries are increasing in both the lower and the upper position limits. We find that position limits can affect current trading strategy even when they are not currently binding and other seemingly intuitive trading strategies can be costly. We also examine the optimal choice of position limits.

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Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 146 (2011)
Issue (Month): 4 (July)
Pages: 1598-1630

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Handle: RePEc:eee:jetheo:v:146:y:2011:i:4:p:1598-1630
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622869

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  1. Acharya, Viral V & Pedersen, Lasse Heje, 2004. "Asset Pricing with Liquidity Risk," CEPR Discussion Papers 4718, C.E.P.R. Discussion Papers.
  2. 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.
  3. Bong-Gyu Jang & Hyeng Keun Koo & Hong Liu & Mark Loewenstein, 2007. "Liquidity Premia and Transaction Costs," Journal of Finance, American Finance Association, vol. 62(5), pages 2329-2366, October.
  4. Domenico Cuoco & Hong Liu, . "Optimal Consumption of a Divisible Durable Good," Rodney L. White Center for Financial Research Working Papers 20-98, Wharton School Rodney L. White Center for Financial Research.
  5. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
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  7. Domenico Cuoco & Hong Liu, 2000. "A Martingale Characterization of Consumption Choices and Hedging Costs with Margin Requirements," Mathematical Finance, Wiley Blackwell, vol. 10(3), pages 355-385.
  8. Amihud, Yakov & Mendelson, Haim & Pedersen, Lasse Heje, 2005. "Liquidity and Asset Prices," MPRA Paper 24768, University Library of Munich, Germany.
  9. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
  10. Hong Liu, 2004. "Optimal Consumption and Investment with Transaction Costs and Multiple Risky Assets," Journal of Finance, American Finance Association, vol. 59(1), pages 289-338, 02.
  11. Min Dai & Yue Kuen Kwok & Jianping Zong, 2008. "Guaranteed Minimum Withdrawal Benefit In Variable Annuities," Mathematical Finance, Wiley Blackwell, vol. 18(4), pages 595-611.
  12. Cuoco, Domenico, 1997. "Optimal Consumption and Equilibrium Prices with Portfolio Constraints and Stochastic Income," Journal of Economic Theory, Elsevier, vol. 72(1), pages 33-73, January.
  13. Hong Liu & Mark Loewenstein, 2002. "Optimal Portfolio Selection with Transaction Costs and Finite Horizons," Review of Financial Studies, Society for Financial Studies, vol. 15(3), pages 805-835.
  14. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 842-62, August.
  15. Edwin J. Elton & Martin J. Gruber & Christopher R. Blake, 2003. "Incentive Fees and Mutual Funds," Journal of Finance, American Finance Association, vol. 58(2), pages 779-804, 04.
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