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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
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    File URL: http://dx.doi.org/10.1287/mnsc.2014.1986
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    Citations

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    Cited by:

    1. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity - Theory and Empirical Evidence," FMG Discussion Papers dp709, Financial Markets Group.
    2. Arthur Korteweg & Roman Kräussl & Patrick Verwijmeren, 2016. "Does it Pay to Invest in Art? A Selection-Corrected Returns Perspective," Review of Financial Studies, Society for Financial Studies, vol. 29(4), pages 1007-1038.
    3. repec:bla:mathfi:v:27:y:2017:i:2:p:401-437 is not listed on IDEAS
    4. DeLisle, R. Jared & McTier, Brian C. & Smedema, Adam R., 2016. "Systematic limited arbitrage and the cross-section of stock returns: Evidence from exchange traded funds," Journal of Banking & Finance, Elsevier, vol. 70(C), pages 118-136.
    5. Morten Sorensen & Neng Wang & Jinqiang Yang, 2014. "Valuing Private Equity," Review of Financial Studies, Society for Financial Studies, vol. 27(7), pages 1977-2021.
    6. Salvatore Federico & Paul Gassiat, 2012. "Viscosity characterization of the value function of an investment-consumption problem in presence of illiquid assets," Papers 1211.1286, arXiv.org.
    7. Campanale, Claudio & Fugazza, Carolina & Gomes, Francisco, 2015. "Life-cycle portfolio choice with liquid and illiquid financial assets," Journal of Monetary Economics, Elsevier, vol. 71(C), pages 67-83.
    8. David Chambers & Elroy Dimson & Justin Foo, 2013. "Keynes, King's, and Endowment Asset Management," NBER Chapters,in: How the Financial Crisis and Great Recession Affected Higher Education, pages 127-150 National Bureau of Economic Research, Inc.
    9. repec:eee:intfin:v:51:y:2017:i:c:p:15-38 is not listed on IDEAS
    10. Dimson, Elroy & Rousseau, Peter L. & Spaenjers, Christophe, 2015. "The price of wine," Journal of Financial Economics, Elsevier, vol. 118(2), pages 431-449.
    11. L. A. Bordag & I. P. Yamshchikov & D. Zhelezov, 2015. "Portfolio optimization in the case of an asset with a given liquidation time distribution," Post-Print hal-01186961, HAL.
    12. Ali Al-Aradi & Sebastian Jaimungal, 2018. "Outperformance and Tracking: Dynamic Asset Allocation for Active and Passive Portfolio Management," Papers 1803.05819, arXiv.org, revised Mar 2018.
    13. Campanale, Claudio & Fugazza, Carolina & Gomes, Francisco J, 2015. "Life-Cycle Portfolio choice with Liquid and Illiquid Assets," CEPR Discussion Papers 10369, C.E.P.R. Discussion Papers.
    14. Dirk Broeders & Kristy Jansen & Bas Werker, 2017. "Pension fund's illiquid assets allocation under liquidity and capital constraints," DNB Working Papers 555, Netherlands Central Bank, Research Department.
    15. Buss, Adrian & Uppal, Raman & Vilkov, Grigory, 2014. "Asset prices in general equilibrium with recursive utility and illiquidity induced by transactions costs," SAFE Working Paper Series 41, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    16. Salvatore Federico & Paul Gassiat & Fausto Gozzi, 2017. "Impact Of Time Illiquidity In A Mixed Market Without Full Observation," Mathematical Finance, Wiley Blackwell, vol. 27(2), pages 401-437, April.
    17. repec:luc:wpaper:13-7 is not listed on IDEAS
    18. I. Halperin & A. Itkin, 2012. "Pricing Illiquid Options with $N+1$ Liquid Proxies Using Mixed Dynamic-Static Hedging," Papers 1209.3503, arXiv.org.

    More about this item

    Keywords

    asset allocation; liquidity; alternative assets; liquidity crises;

    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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