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Portfolio Choice with Illiquid Assets

Author

Listed:
  • Andrew Ang

    (Columbia University, New York, New York 10027; and National Bureau of Economic Research, Cambridge, Massachusetts 02138)

  • Dimitris Papanikolaou

    (Kellogg School of Management, Northwestern University, Evanston, Illinois 60208; and National Bureau of Economic Research, Cambridge, Massachusetts 02138)

  • Mark M. Westerfield

    (Foster School of Business, University of Washington, Seattle, Washington 98195)

Abstract

We present a model of optimal allocation to liquid and illiquid assets, where illiquidity risk results from the restriction that an asset cannot be traded for intervals of uncertain duration. Illiquidity risk leads to increased and state-dependent risk aversion and reduces the allocation to both liquid and illiquid risky assets. Uncertainty about the length of the illiquidity interval, as opposed to a deterministic nontrading interval, is a primary determinant of the cost of illiquidity. We allow market liquidity to vary from “normal” periods, when all assets are fully liquid, to “illiquidity crises,” when some assets can only be traded infrequently. The possibility of a liquidity crisis leads to limited arbitrage in normal times. Investors are willing to forgo 2% of their wealth to hedge against illiquidity crises occurring once every 10 years. This paper was accepted by Itay Goldstein, finance.

Suggested Citation

  • Andrew Ang & Dimitris Papanikolaou & Mark M. Westerfield, 2014. "Portfolio Choice with Illiquid Assets," Management Science, INFORMS, vol. 60(11), pages 2737-2761, November.
  • Handle: RePEc:inm:ormnsc:v:60:y:2014:i:11:p:2737-2761
    DOI: 10.1287/mnsc.2014.1986
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    More about this item

    Keywords

    asset allocation; liquidity; alternative assets; liquidity crises;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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